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Zale Corporation (NYSE:ZLC)

Q3 2006 Earnings Conference Call

May 17, 2006, 9:00am Eastern

Executives:

Betsy Burton, Chief Executive Officer

George Mihalko, Chief Administrative Officer and Chief Financial Officer

Cindy Gordon, Senior Vice President and Comptroller

David Sternblitz, Treasurer

Analysts:

Janet Kloppenburg, JJK Research

Jeff Stein, Key Bank Capital Market

Lauren Levitan, Cowen & Co.

Adrianne Shapira, Goldman Sachs

Brian Tunick, JP Morgan

Mark Bedinger, Stanford Group

Bill Armstrong, CL King & Associates

Justin Boisseau, Gates Capital Management

Robin Merchanson, Sun Trust

Brian Murphy, Merriman Curhan Ford & Co.

Dwayne Fenimore, Clover Park

Jeff Sklegnaly, Stoneberg Fund Management

Operator

Welcome everyone to the Zale Corporation Third Quarter Fiscal Year 2006 Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press *, then 1 on your telephone keypad. If you would like to withdraw your question, press the # key. Thank you. Betsy Burton, Chief Executive Officer, you may begin your conference.

Betsy Burton, Chief Executive Officer.

Thank you. Good morning and thank you for joining us for our third quarter conference call. I am Betsy Burton, acting Chief Executive Officer. With me on the call today are George Mihalko, our acting Chief Administrative Officer and Chief Financial Officer, Cindy Gordon, Senior Vice President and Comptroller, and David Sternblitz, our Treasurer. Before we begin, George will review the Safe Harbour.

George Mihalko, Chief Administrative Officer and Chief Financial Officer

Good morning. Our commentary and responses to your questions on this conference call will contain forward looking statements including statements relating to our expected sales and earnings, future goals, plans and objectives. These forward looking statements are not guarantees of future performance and a variety of factors could cause our actual results to differ materially from the anticipated or expected results expressed in these forward looking statements. Information concerning some of the factors that could cause actual results to differ materially from those contained in the forward looking statement is available in our annual report and Form 10K for the year ended in July 31, 2005, and our quarterly report on Form 10Q for the quarter-end of January 31, 2006 as filed with the SEC. In addition, we will present non-GAAP financial information on this call. For a reconciliation of each non-GAAP financial measure to the most directly comparable GAAP financial measure, please refer to our third quarter 2006 earnings release dated May 17, 2006, today, which can be found on our corporate website, www.zalecorp.com under shareholder information, and then clicking on the news release icon.

Betsy Burton, Chief Executive Officer.

Thank you George. I’d like to start by speaking to the various management changes since our last conference call, as well as the notification of an SEC investigation. First, our Chief Operating Officer, and most recently Mark Lenz, our Chief Financial Officer, were placed on administrative leave. Mark’s leave was the result of failure to timely disclose in conversations with the auditors regarding the delaying of merchandise vendor payments for two weeks at the end of fiscal year ending July 31, 2005. As we stated in the release, the issue of delaying approximately $8 million in merchandise vendor payments does not involve revenues or earnings and the company believes that the fiscal year end balance sheet accurately reflect cash and payables.

With regards to the SEC investigation, we have had discussions with the SEC staff and are cooperating fully. We are reviewing the items they raised, which relate to the areas of extended service agreements, lease, accrued payroll and the timing of certain vendor payments. We believe, based on our current knowledge, that our accounting was appropriate and complied with GAAP.

Now let’s move on. I would like to introduce you to George Mihalko, our acting Chief Administrative Officer and Chief Financial Officer. George was formerly CAO and CFO for the Sports Authority until the merger with Gart Sports in August of 2003. Prior to that he has extensive retail experience at companies including Pamida and Pier One. I worked with George in my capacity as Chair of Audits for the Sports Authority, and am excited to have someone of George’s caliber join the management team.

The executive search for a new CEO is going well. We have identified several excellent candidates and continue to have discussions with them. It is important to note that the board recognizes that we are currently in the throws of finalizing holiday and that the speed of filling the job is not as important as finding the right fit. The brands are focused, energized, and proud of the work done to date, and work yet to be done. I can assure you, whether you call me interim or acting CEO, I am onsite and quite actively engaged in the business.

Now on Q3 results. I am pleased with our comp store sales increase up 2.5%. This is on top of the 3.5% comp increase for Q3 2005. That fiscal performance was delivered during a period of significant leadership change is a testament to the strength of our employees and the strength of the brand. The 2.5% comp store increase translates to an EPS before non-recurring items of $0.24, which exceeds the high end of our guidance of $0.20-$0.22. With the exception of Pagoda, all brands experienced positive comps, including the all-important Zales brand, and if Italian charms were excluded from sales, Pagoda’s comp store increase would actually have been positive.

Diamond fashion was a strong category across all brands, with circle pendants, and of course hearts being top performers. The Zales brand benefited from significant improvements in diamond solitaire as well, where we were missing category assortments last year. Zales Canada used an improved merchandise assortment along with an increase in direct sourcing to positively impact its business. Peoples achieved double-digit comps and 120 basis point improvement in gross margin over last year. Bailey Banks & Biddle had a solid quarter, driven by its successful customer parties, and fashion watches growing at a 20% run rate. Bailey’s continues to take its luxury business to another level, with its average check increasing over 21% in Q3 to $1,763.00 from $1,453.00 the year prior.

Another standout for the period was Zales Outlets since emphasis on its bridal business continues to pay dividends and was a key driver in its success for the quarter. Comps were up in the strong mid single digits, and also delivered a 100 basis point improvement in gross margin versus last year.

On a consolidated basis, gross margins were essentially flat to last year. In the Zales brand, gains due to direct forcing had been mostly offset by clearance and promotional cadence. The Zales brand in particular continues to move through non-going forward merchandise in order to refine its product assortment for holiday. While gross margin rates for the Zales brand was slightly below last year, gross margin dollars were actually higher, due to improving comps. Slightly higher gross margin dollars in the other brands were mostly offset by a larger than expected LIFO charge of $3 million. On the SG&A side, cents control contributed to earnings in line with expectations.

Sometimes, management changes are a good thing. As we discussed on the conference call, John Zimmerman stepped up to the plate with a tall order to fill, and fixed the Zales brand in time to have a great holiday. I am pleased to report tremendous progress on that front. John is probably 70% complete on his merchandise reassortment, and is almost 100% complete in the all important bridal and diamond fashion categories. Orders are being placed and product is expected to flow into stores by the end of August. All stores will then undergo a major reset right after Labor Day. We are also in the process of pre-testing a new TV campaign, and will be adding back key promotion events to the holiday calendar. John has done a terrific job in bringing some of his successes in Canada to the Zales Brands. Some of the operational enhancements he has already made should continue to payout in the new fiscal year.

Let’s now talk about fourth quarter forecast. We are quite pleased with our Mother’s Day results with overall comps in the low double digits, and strong results across all brands. Improved in stock positions, a more aggressive promotional stance, and increase in our marketing spend, and improved executive overall combine to build upon sales momentum from the third quarter. And although not the perfect product assortment, we are pleased that flowing more inventory into the stores has led to more of a serge of our diamond fashion and solitaire businesses in Zales brand. We also historically test product at Mother’s Day to determine key items to incorporate into our holiday plan, and we were pleased with some specific learnings. Since these two weeks represent approximately 25% of sales for the quarter, it is obviously important to the results.

As you recall, we previously said we would not give guidance for Q4 until we had results for Q3. We are now forecasting comp store sales in the low to mid single digits and EPS of $0.0 to +$0.02. We also plan for a flat gross margin primarily due to increased promotional activity and repositioning the product assortment in the Zales brand. Remember, this is not a significant quarter in terms of dollar earnings. Our focus is on being ready for the all important holiday season and capitalizing on the momentum we had going into the new fiscal year. We will announce fiscal 2007 guidance when we announce results for Q4.

Now, I would like to turn the call over to George Mihalko who will add some additional comments on the published financial.

George Mihalko, Chief Administrative Officer and Chief Financial Officer.

Thank you Betsy. I arrived at our corporate offices only two days ago, so it’s been a pretty steep learning curve to prepare for this conference call. However, you may have noticed that we have expanded the financial statements attached to today’s press release by adding some data points for easier analysis. This also includes a table, which reconciles earnings of $0.24 per diluted share before non-recurring benefits and charges, which were listed in the first paragraph of today’s press release to our reported GAAP net earnings of $0.35.

First, I will review the composition of the third quarter income statement before moving onto the balance sheet. Starting with the Q3 income statement, comp store sales increased 2.5% while total revenues increased 4.3% when taking into account the loss of revenues from the daily stores, which were closed in this year’s second quarter. Gross margin for the third quarter was 51.7% versus 52.3% last year. 50 of the 60 basis point decrease in gross margin was due to the $3 million LIFO charged absorbed in cost of sale.

Moving on to selling general and administrative expenses. These expenses increased 160 basis points over last year. Executive severance and additional daily clothing cost accounted for approximately 100 basis points of this increase. Incremental operating costs resulted in a net 40 basis point increase and adoption of FAZ123-R related to stock compensation expense added 20 basis points. GAAP and soft rating earnings amounted to $28 million dollars versus $25 million last year, but included the one time benefit we had to record for the termination of a retirement benefit plan. Interest expense increased by $900,000. Our effective tax rate was slightly lower resulting in GAAP net earnings for the third quarter of $16.8 million versus $14.5 million last year. This equates to diluted net earnings per share of $0.35 this year versus $0.28 last year. The number of shares on which EPS are calculated decreased of course due to the company’s repurchase of approximately $100 million worth of shares earlier this fiscal year.

Now let me move on to the balance sheet. I think I can speak for Betsy as well as myself that we view the balance sheet as the source of funds for prudently reinvesting in and repositioning the operations of our various plants. The year over year changes in our balance are a reflection of this philosophy. Investments in inventory, as well as open market share repurchases are the primary reasons for these changes. In order to strengthen third quarter assortment, especially for the Zales brand, we invested in diamond solitaires and diamond fashion inventory. This also strengthened our merchandised positioning for Mother’s Day. At the same time we also had some gold and silver overstock remaining from the 2005 holiday season. Also, our U.S. dollar denominated inventories including a positive translation adjustment associated with our Canadian inventories due to the substantial increase over last year in the value of the Canadian dollar the U.S. dollar.

Other current assets increased due to higher vendor receivable prepaid advertising and sales induced tax receivable. Accounts payable decreased primarily due to the earlier payment of federal income taxes, this year versus last year. The increase in long-term debt basically finances the changes in the balance sheet items that I just mentioned, as well as the $100 million share repurchase conducted earlier this year, which is reflected in the stockholder’s investment section of the balance sheet. The important takeaway though is that we are investing in our business, and we believe that these investments are starting to payoff operationally.

Betsy Burton, Chief Executive Officer

Thank you George. We will now ask the operator to open the lines for questions.

Question-and-Answer Session

Operator.

Your first question comes from Janet Kloppenburg of JJK Research.

Janet Kloppenburg

Good morning. Betsy, I was wondering if you could talk a little bit about the degree of confidence you’re gaining in Zales with respect to repositioning the assortments, both in terms of having the assortments prepared for Christmas, in other words, what degree of confidence do you have that the assortments will be in optimal shape for optimizing the holiday as much as possible. Also, with respect to the assortment levels, maybe you could talk a little about the degree of fashion product, which was the big emphasis last year versus the more traditional solitaire and traditional diamond product assortment so that we get a better idea of what we might expect. And, with respect to the marketing program, could you talk about how you might want to see that change as we move into Christmas versus last year so that your traffic levels improve. Lastly, if you could talk about the sourcing side of Zales, what’s going on with respect to the degree of product mail being directly sourced. Thank you.

Betsy Burton

Sure, okay lot of questions. I have a high degree of confidence in the Zales repositioning. John Zimmerman, who is a known entity, has been working diligently, literally almost touching every sku trying to determine the right style-out for the new planogram. And, as I indicated earlier, he is 100% complete on the real key categories, which are the bridal and the diamond fashion.

Janet Kloppenburg

Betsy, could I interrupt? Last year, there was some issues with deliveries, the product coming in, they thought it would be in August and then they thought it would all be here in September, crossing our fingers for the beginning of December. Are those issues prevalent this year?

Betsy Burton.

No. I think a lot of that was due to over aggressiveness with regard to trying to negotiate the best cost, and also just pure lateness of trying to place orders. I think, in particular, the finished diamond market, the polished diamond market is a little bit soft and I think that we’ve got some favorable trends working in our favor. I do not believe that there will be that disruption. I think also last year they tried to discontinue and run down the old selection prior to bringing in new products, so there literally was just a lack of product.

The other thing I have confidence in, is that John has a methodology of determining how to put together an assortment based off of taking the bestselling sku and then offering them, you know white gold, yellow gold, different carat, weight, and because of that it’s worked for him very well in Canada and I think it will work very well here where we can dramatically expand the breadth of selection available to our customer, in particular in the diamond solitaire and diamond fashion areas. So I think I am very comfortable with his style, especially in terms of not taking extraordinary risk, sort of going with the tried and true, tweaking it a little, but again sticking with what we know our customer wants.

In terms of the actual assortment itself I think it will be very much back to basics. As you’ll recall last holiday, we pretty much had broken the diamond fashion business and the solitaire business by taking inventory dollars and planning them away from those categories and into gold and silver. What we found is that our customer really wants diamond fashion at holiday, so we are sticking to what we know our customer wants, giving them broader assortments and selection, and making sure we have the product. Again, that will be a shift back to where the assortment that we had which we know our customer wants. Again, shifting a little more of our emphasis back to our core competency, which is diamonds.

Janet Kloppenburg.

But does that mean that this whole fashion jewelry emphasis that was thought to be so important last year has now diminished in terms of focus?

Betsy Burton

We will still have a fashion component, and gold and silver are still doing quite well, but we will not be as lop-sided in terms of our inventory dollars being in gold and silver, and we’ll be putting more back into diamond fashion. For instance, diamond fashion inventory was planned down 45% for last holiday, and we just did not have product that the customer wanted, and that’s clearly something the customer wants for holiday.

Janet Kloppenburg.

Okay, and is that what sold at Mother’s Day?

Betsy Burton

We did quite well; diamond fashion was a highlight across all brands. Yes, diamond fashion is absolutely hot right now whether it’s circle pendants, circles within circles within circles, everything diamond fashion seems to sell.

In terms of marketing, we are clearly in the throws of testing a new marketing campaign. I think there will also be a tweaking of our media buy. Rather than spreaded out over a week, we are going to try to have heavier points directed to our key promotional events, which we believe will help increase foot traffic and get greater efficiency out of our marketing dollars. So, we are excited about some of the changes we are making in particular to the media buy, as well as the creative. Direct sourcing continues to be an initiative. As you can see, we are continuing in some of the brands to see as much as 100 basis points of improvement. Again, there is a little bit of noise in the Zale brand in particular because of the clearance and the markdowns to try to move through the products so that we can clear the way for the new product assortment.

Janet Kloppenburg

Thank you.

Operator

Our next question comes from Jeff Stein of Key Bank.

Jeff Stein

Good morning Betsy. Can you talk about the SEC investigation and any impact its having on recruiting a new CEO, and then along with that, what’s the new timetable for expecting the “right person” to be hired?

Betsy Burton

In terms of the SEC investigation, again we are in discussion with the SEC. We do not at this point have any concerns about that affecting our CEO search. In think that the candidates that we have been in conversation with are still candidates, in other words, no one has dropped out as a result of the investigation. In terms of timeframe, I think the board is comfortable in that we had originally said 3-6 months, and I think we will still be able to deliver within that timeframe.

Jeff Stein

Second question is, could you give some information on comps by brand in the third quarter maybe?

Betsy Burton

We typically don’t do that for competitive reasons. I would be reluctant to do that. But again, I think I did indicate the all-important Zale brand did actually have a positive comp, which is the headline.

Jeff Stein

Thank you.

Operator

Next question comes from Lauren Levitan of Cowen & Co.

Lauren Levitan

Thank you and good morning. Could you elaborate a little bit more on what you’ve learned from Mother’s Day, Betsy, and also give us a little bit of a sense of what drove that strong business. I’m curious if you were particularly or incrementally promotional besides those Zales clearances issues. But, were you particularly promotional to drive the double-digit comp over Mother’s Day, and help us reconcile that strong comp and the EPS guidance, which I’m assuming has impacted the ongoing repositioning initiatives at Zales. I’m wondering if there is anything else impacting it. Then, separately, we all know that medal costs continue to hit new highs. You had a LIFO charge in the third quarter. Could you talk about what you’re seeing in terms of raw materials pricing? Of how your costed out products are currently versus spot pricing, and whether or not we should be anticipating further LIFO charges given the ongoing increases in the medals markets. Thanks very much.

Betsy Burton

Sure. Lets talk about Mother’s Day. At Mother’s Day, we found, in particular, certain price points and certain items were very successful. As you know, we ran a half-carat diamond circle pendant for $199.00, and it was extremely successfully. We had other categories in general that were just very hot, and I think overall it was a combination of our promotional cadence, but also just having the right product, and the right product assortment. There were a number of items that again we tried to determine their potential. We learned from that and incorporate that into our holiday offering. Again, it was just an overall great performance and I think by flowing a lot of product into the stores, the associates just had a lot more sell.

The EPS guidance, if you sort of back into it, I think the prior management had guidance of $0.07, and I think if you look at the guidance that we’ve given for Q3, relative to prior management’s guidance, it’s in parity. In other words, we’re expecting a similar performance in Q4 to what we saw in Q3, and I think we all indicated all along that what we wanted to do is make sure we repositioned the company so that in the all important Q2, we had the product assortment right. So, I think that is still our focus. Again, this is a relatively unimportant quarter in terms of actual earnings, and if you look at the delta, in terms of the, lets call it, $0.07 between what consensus is and what were projecting, more than half of that is because of the Zale brand and the give-up of some gross margin in order to clear through the product inventory.

With regard to medals, yes, the cost of gold gives us heartburn, and we have for the first time really hedged across all brands for the cost of gold in particular. So, we are very comfortable that we were able to hedge at a good price early enough in the game, and feel comfortable that because of that, we can price our program and be consistent in that pricing throughout the holiday season.

Lauren Levitan

One follow-up Betsy with respects to marketing. I know you talked about possibly reorienting the actual media buy. Can you talk about who the target customer will be and what the message might look like in the new Zales campaign, given last year was really a pretty significant departure that I think really wasn’t what you had hoped in terms of drawing in a broader customer base or younger customer base. Who should be we expecting the revamped campaigns to be targeting?

Betsy Burton

The campaign is really targeted towards any gift giver. It’s Middle America, so at gift time we don’t really sku male or female, it’s anyone again in the middle market. We are probably this year going to spend more on prime-time, just because that’s where you can reach the most people, and I think that change will hopefully be a much more effective use of our dollars, even the frequency will not be as great. In terms of the costs themselves, it would be a combination of product and promotional spots. Obviously, we’re not going to talk about the theme itself, but we’re excited that we believe it will appeal to our customer base, and also help sell product and get foot traffic into the stores.

Lauren Levitan

And was the Mother’s Day TV campaign for Zales, was that using some of these revised filters, and did that meet your expectations?

Betsy Burton

The Mother’s Day campaign, we did not have the luxury of really developing new creatives, so that was sort of a jerry-rig, we did the best we could, and that actually was reasonable and effective given the inability to develop new creatives. We were actually quite pleased. I think it was a combination of not just the creative, but also the promotions and the product itself.

Lauren Levitan

Right, thanks and good luck.

Operator

Our next question comes from Adrianne Shapira of Goldman Sachs.

Adrianne Shapira

Thank you. Betsy, just following up on the marketing. Any decision to revert back to your prior agency? We’ve noticed the diamond store tag line coming back to commercials, so I don’t know if any decision has been made to change back agencies.

Betsy Burton

No, we are sticking with the Richards Group. We have however, changed creative teams within the agency, but there is no intent at this point of changing agencies. But, yes, you are correct in terms of, our belief is we really had a franchise built around the diamond store, and we felt that bringing that back, whether it’s in a subtle way, or even in a more direct way would be important to the success of our creatives.

Adrianne Shapira

Okay, and could you share with us any lift you’re seeing in traffic in some markets where you did test the new marketing campaign?

Betsy Burton.

We have not tested it, the actual TV campaign itself. We are testing , so we really don’t have any results from actual testing airtime of the commercials.

Adrianne Shapira

Okay, then could you just give us a sense of maybe any traffic changes in the Zales comp? You mentioned obviously encouraging Mother’s Day trends. But if you could just aggregate ticket versus traffic in the comp?

Betsy Burton

Actually traffic is driving the comps, not average tickets. So, clearly it’s a combination of customer count. We don’t really have customer counters, but it’s increased traffic as well as increased transaction.

Adrianne Shapira

Then you had mentioned that you’re adding back some promotion. When do you plan to add those promotions back, and how much did dropping those events last year cost you?

Betsy Burton

The key events that we will be adding back are Veterans Day, Thanksgiving weekend, the first week of December, we had some bonus days advertised, so those are the key events that we did not anniversary last year, and that cost us about $ 22 million in sales last year for lack of those promotions.

Adrianne Shapira

Okay, that’s helpful. And, lastly, the guidance on fourth quarter, any charges in that guidance?

Betsy Burton

I think for the most part there’s a little bit of clean up, in terms of Baileys just minor, but nothing out of the ordinary.

Adrianne Shapira

Lastly, obviously we know of some of the vacancies at the senior level. We’re hearing some other vacant spots in the person heading up diamond sourcing. Could you just speak to the upheaval and the changes on John’s team, and how solid that bench is?

Betsy Burton

Okay. Adrianne, as you well know we really don’t talk about personal issues and people in particular, but we actually believe that we have added some real strength into our diamond sourcing area. We took Gil, who is our President of Pagoda, who is our guru in terms of direct sourcing of gold, and he is now President of Corporate Sourcing in addition to Pagoda, and he now has someone that we took out of the Zale brand that is extremely strong in terms of diamonds, and is heading up the diamond sourcing underneath him. So, we actually added bench strength to the diamond sourcing area in particular. In terms of John’s area, he has done a great job of building his team. The nice thing about taking and merging the Peoples brand and the Zale brand to develop a North America brand is that you get to combine the merchandising teams so you can pick the best of the best. So, I think John is very confidant in his team, and again with the leadership that he can provide in think we’re very happy the bench.

Adrianne Shapira

Thank you.

Operator

The next question comes from Brian Tunick of JP Morgan.

Brian Tunick

Hi, thanks, good morning. A couple questions. I guess the first one maybe if you could comment on the debt on the balance sheets. It seems to be a little higher than we were projecting, which ties into maybe your capital structure target/buyback thoughts for the year, and then maybe give us your cash flow estimates for 2006/2007. That would be great, that’s question number one.

Betsy Burton

I think that is higher for a couple of reasons. As George indicated, we’re building inventory, we’re putting more inventory into our stores. The other, you’re absolutely right, we did buy $100 million worth of stock, and as you know we usually pay that down when we get cash from the holidays. I think again, we’re investing in the business in terms of in particular product, and making sure we have the right product, and because of that, that is higher than what would normally be. We do not, at this point, since we are not announcing our fiscal 2007 numbers, we really are not prepared to give any pre-cash flow estimate at this point. We are still awaiting for some components of that plan, in particular what the impact will be of the change out in terms of it’s impact on inventory. Again, when we announce Q4 and give guidance for fiscal 2007, we will provide a look at what our free cash flow is expected to be.

Brian Tunick

Okay. Would you also comment on you’re capital structure targets, how much debt, the EBITDA you’d feel comfortable running with, things like that as you progress through the year?

Betsy Burton

Yes.

Brian Tunick

Okay, then my second question. I think the question when you first started with the business recently, and relative to what you’re seeing in Kay and some of the other mall-based jewelry retailers, versus the off mall and online, I mean it certainly seems like the Zales division is under solved by different channels. Any thoughts of anything that’s changed recently?

Betsy Burton

We obviously are looking at Kay and their Jared’s division, as they are aggressively looking to open more stores, and we are actually being a lot more aggressive with regard to looking at alternative locations. For instance, the outlet stores are doing exceptionally well, the powered center concept in selected markets, so we are looking at different locations. We will be testing our first free-standing out-lot Bailey Banks & Biddle, which I think most of the analysts liken Jareds more to our Bailey Banks & Biddle division than they do to the Zales division itself. I think we believe that we are clearly back on track in regaining market share, and don’t know who the market share is coming from, but we are just pleased that we are seeing the positive traction.

Brian Tunick

Thanks and good luck.

Operator

Our next question comes from Mark Bedinger from Stanford Group.

Mark Bedinger

Hi Betsy, how are you?

Betsy Burton

Good.

Mark Bedinger

A couple of things. The Q4, you were saying comp store sales of low to mid single digits?

Betsy Burton

Correct.

Mark Bedinger

Okay, that’s for Zale Corp, or would you assume Zales would be positive?

Betsy Burton

Yes, that’s a consolidated number and yes Zales is positive.

Mark Bedinger

Okay, and with that to get down to flat earnings to $0.02, you’re assuming that the gross margin is coming in? Or is it on the SG&A side?

Betsy Burton

Gross margin will be flat. In other words, because even though we’ve got improvements due to direct sourcing, its being offset primarily in the Zale brand by the clearance of merchandise to make way for the new product assortment.

Mark Bedinger

Okay, and a LIFO charge?

Betsy Burton

Yes.

Mark Bedinger

So, really clearance and LIFO are what’s doing it.

Betsy Burton

Right, and then you add to that interest expense and options expense, and you’re right there.

Mark Bedinger

Okay, have you been increasing price points?

Betsy Burton

Some of the brands have already priced up. We are waiting on the key Zale brand. We wanted to get through the Mother’s Day season, but we will be repricing, and will be complete with that pricing, and then we believe that because of our hedge, we’ll be able to hold that pricing.

Mark Bedinger

With respect to John’s evaluation of the Zales brand, I believe that was talked about and we wanted to know where he is on that?

Betsy Burton

I’m sorry, in terms of his…?

Mark Bedinger

I think there was talk of when John came in, he was going to do an evaluation of the brand from top to bottom, kind of take a look at it, do an analysis. Is that complete? Are they any conclusions from it that you can talk about?

Betsy Burton

Sure. He has completed his analysis. He has made certain operational changes, which I call ‘improved discipline’, and more importantly again the product assortment is what he felt was the biggest opportunity. I think we are investing in our people in terms of refocusing some of our training initiatives, and he has introduced some new incentives, which have energized our field, so I think he has made some good operational changes. Again, not reinventing the wheel, but simply taking some things that were working well for him in Canada, bringing them here, and again I call that the ‘low-hanging fruit’. So, he has completed that. A lot of the changes in terms of operational changes have already been put in place, and again the product assortment we hope to have everything redone and completed shortly after Labor Day.

Mark Bedinger

And with respect to diamond prices, I know gold prices are pretty hard to find, can you comment on how the diamond price is going?

Betsy Burton

We are not as concerned about inflation in diamonds. Again, polished is sort of a soft market out there. So, the bigger story line is in gold and silver.

Mark Bedinger

Okay, but the majority of what you do is in diamonds, correct, so how much was it upwards last year? Or is it down?

Betsy Burton

It’s not down, but it’s fairly constant. In other words, really the gold component is what’s causing the inflation.

Mark Bedinger

The last question would be, in terms of a message that you send to customers, investors, what is going to differentiate Zales from the competition whether its now or looking forward to the holiday season? I don’t mean just building up your assortment, your inventory, which is kind of a correction from last year, but really something that is going to set the company apart from Kay or Jared, to draw in the customers?

Betsy Burton.

Clearly, product is certainly something, but in addition to that I think that the Zales brand is in and of itself a differentiator. We have a tremendous amount of loyalty to the brand. We even have people come in and want to buy a Zale box to put a piece of jewelry in, so we just have a tremendous franchise. I think to go back to our roots; to recapture the hearts of the people who love Zales, I think is our real opportunity.

Mark Bedinger

Thank you Betsy, good luck.

Operator

Next question comes from Bill Armstrong of CL King & Associates.

Bill Armstrong

Hi, good morning. With Mother’s Day up low double digits, it sounds like your quarterly sales guide might be a little conservative, or why so much lower than the Mother’s Day? Are you expecting some sort of deceleration?

Betsy Burton

Well, it’s just that Mother’s Day is our one opportunity in terms of foot traffic in the mall. So, we develop a plan day-by-day, week-by-week. I don’t believe its conservatism; it’s based off of actual plan by brand, which again I think is realistic, not overly conservative.

Bill Armstrong

Would you characterize Mother’s Day as coming in above your original expectation?

Betsy Burton

Yes, we came in about 4.5% over plan.

Bill Armstrong

Just to be clear, the previous original guidance for the quarter was $0.07-$0.08 per share, and you’re at $0.01 - $0.02, where is the delta there, especially since it looks like sales are coming in better than original expectations from prior management?

Betsy Burton

Sure. About $0.04 is due to the Zale brand, and again the margin pressure due to the desire to move through as much of the non-going forward merchandise as possible. So, again, it’s driven by pressure in the Zale brand. Obviously you’ve got increasing rents in payroll, and the actual comp sales will not offset the actual declining gross margin. So, that’s really the story line. The other $0.02-$0.03 is in SG&A, which would be interest expense and options. So, it’s really much in parity if you look at what the prior management’s guidance was for Q3, and what we ended up with, similar.

Bill Armstrong

I understand. With the SEC investigation, can you give us any update? Have they given you any specific information as to what they are aiming or what they are actually investigating?

Betsy Burton

They sort of highlighted in the subpoena the areas that they have of interest, and as we indicated before, primarily they’re interested in the vendor payments. They are also looking into the lease accounting; they’re looking into our extended service agreements and our payroll accruals. It’s our belief, and again we are cooperating and communicating with the SEC, it’s our understanding that mostly these SEC investigations are fact-finding, and the SEC indicates in the subpoena cover letters that the fact of the investigation, and the issuance of the subpoenas does not mean that the SEC has concluded that we’ve done anything wrong. So, we really look at this as fact-finding, we’re fully cooperative. A lot of these issues are issues that we’ve had conversations and discussions with the SEC before. So, again, that is as much as we know at this stage.

Bill Armstrong

So, you’re not aware of any red flag that somehow came up that got them interested in you?

Betsy Burton.

No, typically when you have as much turnover, especially when you have your CEO and your COO turn, I think that’s probably a red flag.

Bill Armstrong

Just a couple housekeeping questions. Could you just clarify what that $0.17 retirement settlement benefit was, and also could you give us the store openings and closings during the quarter, and then just what the store base at the end of the quarter by division?

Betsy Burton

Sure. We eliminated the medical retiree program, and that decision was in April, and because of GAAP, it is required that we record into the income for this quarter. So, it is a non-recurring event, just a decision not to continue with the medical retiree program. In terms of the store count, it was a relatively small number of stores opened, 14 stores opened in total and 5 kiosks. In terms of the closing, 11 closed, of which …I’m sorry 15 kiosks. So, basically ups and downs basically, not a lot of net movement.

Bill Armstrong

And what did the store bases look like at the end of the quarter by division?

Betsy Burton

Zales, 783, Gordons, 289, Baileys, 73, outlet 131, Peoples 172, Peoples 2 Carts, 75, Piercing Pagoda, 821, and then these three Master Jewelry stores. So, a total of 2,347.

Bill Armstrong

Okay, thanks a lot.

Operator

Our next question comes from Justin Boisseau of Gates Capital Management.

Justin Boisseau

I got a couple questions. First of all, your cash taxes seem to be consistently running below the provisional rate, what do you expect that to be on a go forward basis, number one, and a percentage of the provision? And, secondly you’re other assets are up year over year, can you give us a little help on what’s driving that?

Betsy Burton

The tax raise is running approximately 37.2, which is pretty much our normal rate that we’ve been running.

Justin Boisseau

What about the cash tax portion of that, though? The amount you actually pay has been considerably less than that?

Betsy Burton

You know what, we’ll get back to you on that. That’s not something that any of us were focused on, but we will look at that. In terms of other assets, it was in increase in vendor receivable.

Justin Boisseau

Okay, and can you tell us the inventory last year, the level of the inventory level last year excluding the Bailey Banks & Biddle stores that you closed?

Betsy Burton.

Sure, just a minute...

Operator

Our next question comes from Robin Merchanson of Sun Trust

Robin Merchanson

Can you share any comments with us regarding how flexible you can be in terms of managing inventory and/or marketing programs, as you look to the remainder of this calendar year, first half of your new fiscal year, if you need to be, in the event that consumer was down? Thank you.

Betsy Burton

I’m sorry, back to the Bailey Banks & Biddle inventory question, the decline in the inventory was $18 million. And could you re-ask your question? We were focused on the other one.

Robin Merchanson

Sure, if you could share any thoughts with us regarding how flexible you could be in terms of managing inventory or marketing programs if you need to be defensive in the back half of this calendar year?

Betsy Burton

We are clearly flexible in how we’ve managed through the inventory. I think the goal here is to make sure that there is no disruption, that we have a good product assortment at all times, and that we take a disciplined approach to moving through the non-going forward inventory. As you know, we have three main gift-giving occasions, you’ve got Valentine’s, Mother’s Day and holiday, and two have come and gone. So, in terms of being aggressive on the marketing side probably would not be a good use of our marketing spend, so I don’t anticipate any shift in our heavy dollar expenditure, which occurs in the holiday season.

Robin Merchanson

Let me ask a different way. How do you view the consumer going into the first half of your new fiscal year?

Betsy Burton

Going into the first half, we’re very encouraged. We are definitely pleased with the traffic. We are pleased with the transactions. We don’t, at this point seem to be concerned about the customer pulling back. I think that engagement rings, and then again diamond fashion at holiday are things that the consumer will continue to want to buy. I think they will buy them, it’s just who they chose to buy them from. We have not seen any resistance. Perhaps, the only potential concern is the Pagoda customer, who as you know, especially the teen part of the core customer basis might be impacted by the increase in gas, less disposable income. But, given it’s relatively diminutus impact on our consolidated; we really don’t overall have any concerns about the flowing of spending.

Robin Merchanson

Thank you very much.

Operator

Our next question comes from Brian Murphy of Merriman Curhan Ford & Co.

Brian Murphy

Good morning. I was wondering if you could just speak briefly to your moissanite product line and the concepts in which it is being sold, contributions to gross margins, and whether you see that selection expanding or contracting in the coming quarters.

Betsy Burton

Sure, moissanite right now we treat it mostly on a trunk show basis, in particular in the Gordons division. The outlet division is actually bringing it in line into case. It’s interesting, it is clearly a self-purchaser. We find that our Zale outlet customer tends to be slightly more affluent and we find it appeals to customers in particular who want big bang for the buck, and want to take it on vacation to the beach where they don’t have to worry about their higher ticket, higher value jewels. So, it definitely has a place in our permanent selection in the outlet store, and again to be determined with regard to some of the other divisions.

Brian Murphy

Got it thank you.

Operator

Our next question comes from Dwayne Fenimore of Clover Park

Dwayne Fenimore

Congratulations on a good quarter. I just have one question. How would you characterize the new provisions to the training program you’re putting you’re Zales associates through as compared to say a year ago?

Betsy Burton

Good question. I think there is more emphasis on product knowledge training, and we’re finding that is what our associates really want. It gives them greater confidence in their job. So, I think that the trading off of dollars what we used to put into what I call ‘soft skills’, you know time management, leadership, etc., we are putting more of those dollars into actual product knowledge training, and in particular diamonds.

Dwayne Fenimore

Okay, what’s the specific program?

Betsy Burton

It’s an inhouse program. There is a certification program for diamondtologists, which we offer to all of our associates, sort of an online training they can take on their own time.

Dwayne Fenimore

Thank you.

Operator

Our next question comes from Mark Bedinger of Stanford Group.

Mark Bedinger

Just a follow-up. Nice rebound in the stock in the last 20 minutes, you’ve had about a 12-13 point percent swing. You were down 4, now you’re up 8. Just, in terms of George, for the extraordinary charges here, do you have the pretext dollars, and would they wall in SG&A, or was some of this influx goods sold as well?

George Mihalko

All of the items were either SG&A items or the benefit from settlement of retirement obligations, was a separate line item.

Mark Bedinger

Okay, so that’s the $84.17 after tax?

George Mihalko

Right, and the tax rate that I believe would apply to that was 37.2, so severance pretax was 3.6, the Bailey Banks & Biddle was 1.5, and then the benefit from settlement of retirement obligation is actually shown in the income statement…

Mark Bedinger

Right, that’s the 13.4...

George Mihalko

...on the preline, pretax basis.

Mark Bedinger

Okay, so the only thing that hit SG&A was the severance and the Bailey Banks & Biddle charges?

George Mihalko

Correct.

Mark Bedinger

Okay, great thank you very much.

Betsy Burton.

And just for your information, severance was really only the CEO and the COO. All other included in SG&A is normal course.

Operator

Our next question comes from Jeff Skegnaly of Stoneberg Fund Management

Jeff Sklegnaly

Good morning and congratulations on a good quarter. One of the questions that I have. It just seems to me now that given the dramatic overturning of the management team, you have a new CEO search, and the beating that the stock has been taking over the last few months, as well as cheap evaluation both on earnings and on book value, it seems to me that now is a natural transition point to consider selling the company versus going through a new CEO search and essentially rebuilding the management team. I am curious why the Board of Directors isn’t considering that?

Betsy Burton

The Board of Directors has been really heroic here in terms of supporting me, and we meet literally weekly, whether physically or on the phone, and they have become very engaged. I think the Board recognizes the potential that the Zale brand has, and why put the company up for sale when you’ve got the opportunity to fix it and provide the value to existing shareholders. The Board is very confident that we will be able to do that, and again the early indications are that the Board is correct. Does that answer your question?

Jeff Sklegnaly

It did, I think that it’s something the Board should consider. Obviously the Zale brand has a lot of value and I think the Board should consider assessing whether or not you could get paid for that today, given all the private equity money out there, and given the risk inherent in essentially rebuilding the management team. I think it’s something that the Board should weigh as an alternative. I think the people feel you’ve done a very good job since you’ve been there in turning the business around. I think the results speak for themselves today. But, I think that given the work that you’ve done, which is very impressive in the short amount of time, I think it could be a natural transition point where someone could pay you for a lot of the upside inherent in the brands right now.

Betsy Burton

Clearly, it’s not our policy to comment on that, but I will take your comments to the Board.

Jeff Sklegnaly

Thank you.

Betsy Burton

Sure.

Operator

Our next question comes from Bill Armstrong of CL King & Associates.

Bill Armstrong

Yeah, I just had a follow-up. Betsy, on your last conference call three months ago you identified three major differences between Zale and Kay. I think product, advertising, and training of the store employees. Product, you’re obviously working on advertising. I guess we’ll see how that plays out as we move into the holiday. I want to ask about the training and knowledge base of the store employees. What initiatives are being undertaken by management right now to close that gap between Zale and Kay?

Betsy Burton

We believe that training has actually been one of our strengths. We also need to say that Kay would hire our people because we did such a good job of training them. I think we’ve always had a good program, but we are trying to improve upon it, again in offering certifications, giving our people advance training, which gives them confidence in their jobs. I think we also are looking at training not just in the field, but also in the corporate headquarters as well in terms of testing some new indoctrination programs for buyers, etc. So, it’s a comprehensive approach to really investing in our people to make sure we give the customer what they want.

Bill Armstrong

So, what you’re saying now is that there really isn’t a deficit, if you will, between the training of Zale employees versus Kay employees.

Betsy Burton

Not knowing what their program is, it would be really hard for me to say, but I believe we find it very valuable, we feel very comfortable, we’ve got a great training program, and again, if anything, we’re shifting more dollars away from some of the softer skills, not all of them. But, for instance, instead of time management being taught to all of our sales associates, we really are just going to do it with newly promoted or about to be promoted managers. So, being smart about what we teach, being a little more specific to the brand as opposed to generic training are some of the enhancements we’re making.

Bill Armstrong

So, you feel like product knowledge is adequate?

Betsy burton

I feel very comfortable that we have a great product knowledge-training program and that our associates are taking advantage of that program.

Operator

That’s ends our Q&A at this time.

Betsy Burton

Okay, thank you all for you time, and as usual we will be available for any additional questions.

Operator

Thank you for participating in Zale Corporation Third Quarter 2006 Conference Call.

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Source: Zale Corporation Q3 2006 Earnings Conference Call Transcript (ZLC)
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