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Zale Corporation (NYSE:ZLC)

March 12, 2013 2:50 pm ET

Executives

Matthew W. Appel - Chief Administrative Officer

Thomas A. Haubenstricker - Chief Financial Officer and Senior Vice President

Analysts

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Very happy today to have the management team for Zale here. We have Tom Haubenstricker and Matt Appel. I'm going to pass the microphone over to Matt first who will give a quick overview of Zale. Tom will chime in with some financial metrics, and then we'll turn it over to the audience for questions.

Matthew W. Appel

Thanks, Lorraine. Thanks to everybody who's here today and who's listening to us on the web. Apologies for my voice. If you can't make out what I'm saying, we'll have Tom repeat it when he gets up here right after me. First, I'd like to draw your attention to the Safe Harbor statement. I'm not going to read, in fact, any of it, let alone every word, customary cautions about forward-looking statements and non-GAAP measurements.

Moving ahead to #3, Slide #3, I'd like to talk a little bit about Zale at a high level. We're one of the leading specialty retailers of fine jewelry in North America. We operate 6 brands, throughout the United States, Canada and Puerto Rico. We have just over 1,100 Fine Jewelry stores that operate under the Zales Jewelers, Zales Outlet, Gordon's Jewelers, Peoples Jewellers and Mappins Jewellers brands, and then we operate slightly more than 640 kiosks, principally under the Piercing Pagoda name, and located principally in shopping malls and we have web stores for all the brands, except for Mappins. So we operate 5 different web stores. Of course, we trade on the New York Stock Exchange under the symbol of ZLC.

A little bit of our financial profile for fiscal '12. This is our sales breakdown out of the $1.9 billion that we reported for the fiscal year that ended July 31, 2012. Just over 61% of the business constitutes the Zale brand, so Zales and Zales Outlet, with Zales Jewelers constituting just slightly more than 50%. Our U.S. regional brand, which is Gordon's, adds 9% so a total of 70% in mall-based and outlet-based in the U.S. Our Canadian brands, Peoples and Mappins, contribute 17% and Piercing Pagoda, the Kiosk business, contributes about 13% of our sales volume. For those of you who have been following Zale during our 3-year turnaround, this is the third year of the turnaround. This is a familiar chart to you. What this chart does is characterize the initiatives that we've worked through in order to bring Zale's back from the position that we found ourselves in at the beginning of calendar 2010 to where we are today, about to record our first fiscal year profit in quite a number of years. First act was stabilizing the business, which we did through a series of initiatives that included hiring a capable executive team. We pooled together our corporate -- our multiyear turnaround strategy rather. We secured some financing that was required in order to invest in turning around the business and began working through our inventory issues in order to record, to restore our core merchandise assortment.

During the ensuing 2 years, we managed to restore the inventory back from a 60% core to 85%. We posted 7 consecutive quarters of positive comps, which are now 9 consecutive quarters of positive comps. We posted our first annual operating profit in the last fiscal year at $19 million, and we once again improved our capital structure beyond the 2010 capital raise. More relevant is what you see in the right-hand column, what we are doing this year, expanding our exclusive and branded collections, principally Vera and Celebration, which now represents 10% of our product mix and we have an objective to grow to 20%, building on our Omni-Channel strengths, which I'll talk to you about in a minute, driving store productivity a little harder, significantly investing in expanded training for our stores and store personnel, stabilizing and growing Pagoda and beginning a very important multiyear implementation to improve our sourcing framework, which is really focused on a wide range of elements in the supply chain to lower -- both lower our costs and drive higher margins.

Turning to Page -- to Slide 6. I'd like to briefly review the key drivers that we're relying on for growth. First and foremost, our strong brand equity. Capitalizing on the traction of our core brands, our core national brands, the Zales brands in the U.S. and the Peoples brand in Canada. Merchandise, I'll talk to you about on the next slide.

In terms of the Omni-Channel business model, leveraging the already strong web presence that we have, an e-business that constitutes between 4% and 5% of our sales, but in adding the dimensions of Ship-to-Store and leveraging social media, embracing mobile. For example, over the past holiday season, over 23% of our online orders, that was in November and December were through the Ship-to-Store model, and over 42% of our traffic during the holiday season was mobile, and in the last week leading up to Christmas, that grew to 50%. And so this is a very important integration point for us and one that we've worked very hard on. In terms of credit, warranty and repair, we're talking about as customer credit, and we've expanding those capabilities by adding an alternative financing program that sits under our prime U.S. program, and has expanded the reach of our proprietary program, but also by focusing on higher margin service oriented programs such as warranty and repair to both enhance the value of the services that we offer to our guests, as well as to drive higher margins. Last but not least, focusing on both attracting higher quality store personnel and then retaining the folks that we value by investing in training across a wide variety of spectrums, including product, as well as our service and selling model.

Let me finish my remarks before I turn it over to Tom and speak to you about the merchandise. We now stand at 85% core. We started the turnaround at 60%, and so we've moved $150 million of inventory out of non-core programs into core. I've already mentioned the importance of an exclusive and branded product, standing at 10% today, represented principally by Vera and Celebration. We intend to growth this to at least 20% within the next 3 years. And of course, within that, the way we will grow it is by not only adding more stores. Currently, we're in 680 stores for Vera. We're going to grow that to 745 before Mother's Day. We're adding SKUs across the program, and we're doing a similar thing within the Celebration program, expanding the reach of the Celebration Fire, the best diamond offered in that program, the most brilliant diamond in the world, to make it more available to our guests throughout the U.S. and Canada. Tests of additional branded and exclusive products are ongoing. I will speak about the new products as we introduce them. Thank you. Tom, why don't I turn it over to you?

Thomas A. Haubenstricker

Thank you, Matt. Good afternoon, everyone. I'm going to begin my comments on Slide 8. I want to start with reviewing our revenue performance, our quarterly revenue performance over the past several years. Now as you can see in the chart, indicated by the green bars, we have produced a positive comparable store sale result over the last 9 quarters, and this restoration of predictable, sustainable growth really lies at the foundation of the turnaround that Matt talked about. When we look at the building blocks of what's driving this growth, whether it's the improvements to the merchandise assortment, the refinements to our marketing program or the improvements to our training and credit programs, we really see building blocks that we're confident we can continue with in the future. Our Zales brand, as Matt said, which represents about over 60% of the business, has laid at the heart of this growth story. In fact, the Zales brand has posted a 10% or greater comp in many of these quarters. I think it's noteworthy that this revenue performance has been achieved over a period of time that we believe represents a challenging time economically for our core customers. And as I stated before, the growth that we're achieving on the top line over this period of time not only has lifted us financially over this period, but it also has given us a clear visibility on a foundation standpoint of what works well and what we're going to be able to leverage going forward to continue this growth.

So our focus over the last couple of years, as we're driving the business turnaround, has been far beyond just top line. And as you can see on Slide 9, we've also been very focused on driving bottom line net income improvement, and this slide walks the improvement that we've made over the first half of our fiscal 2013, and this slide starts at looking at our first half net loss for 2012, which you can see here, was a loss of $3 million, and really walks through the year-on-year improvements that we've been able to achieve over 12 months. You can see here, we've generated $7 million of improvement on our gross margin line. That's a result of the positive comp sales we've achieved over those first 2 quarters, along with a steady gross margin. We've invested some of that back, $3.5 million, in growth initiatives. I will say that our SG&A rate in the first half of this year is lower as a percent of revenue than the first half of last year. But in absolute dollars, we have made investments in growth areas that we believe are supporting the business today and into the future.

A key part of our profit improvement has been the work done that Matt mentioned briefly on the debt structure, the refinancing transaction that took place last summer, and that was a major catalyst in really driving bottom line improvement for the company. During that refinancing, the work that we did, supported by our partner, Bank of America, enabled us to reduce our average borrowing cost from 8% down to 4%. It also improved our access to liquidity going forward and gave us more flexible business terms in which to conduct the business over the next couple of years. So in the first half, that lowering of the borrowing cost contributed $8 million to the improvement in our overall net income. And then you can see the rest of the slide other expense improvements that we made to various areas, all leading up to $16 million of improvement in net income, first half of 2013 versus the first half of 2012. As we've talked about before, a very important milestone for us to achieve this year is to generate a net income profit, a positive profit, and this is a good illustration of, at least in the first half, of turning losses in the past into a meaningful profit going forward.

I think the last couple slides demonstrate that our turnaround is really balanced between generating better top line performance, which we believe is key to the future, as well as efficiency, margin, interest cost improvements that are driving better net income. Another example of that, in a different horizon, if you look at Slide 10, is really looking at on a full year basis our trailing fourth quarter net loss or net income position. So this really takes you back to the end of the fourth quarter fiscal 2011, where the company had just finished posting results for the year of a loss of $112 million. And it shows the progression, again, measured on a trailing 4-quarter basis, every quarter over the last couple of years, where if you look at the second quarter results that we just reported and on a trailing 4-quarter basis, that loss is narrowed from $112 million now to just negative $11 million, and we've done that through the drivers that I just talked about, better top line growth, better SG&A leverage and then interest expense savings. We see those drivers absolutely continuing to drive the business favorably in the second half of the year and remain confident in achieving our goal for the year of achieving a positive net income in fiscal 2013.

If we move to Slide 11, we want to talk a little bit about what's beyond 2013. And while achieving a positive profit in that year is a very important milestone for the company, we realize that the key to the shareholder value creation is going to be sustaining and then accelerating profitable growth in these next couple of years, and our -- well, to do that, we'll focus on a number of key areas. First, top line growth is going to be a critical element as it has been in the past. Matt had talked about the changes we intend to implement over time to our merchandise assortment, really leveraging on the success that we can see over the past several quarters with our exclusive branded products. And we really see that as a cornerstone to our top line growth, taking the composition of the portfolio from 10% today to 20% over the next couple of years, and we'll also be focusing very heavily on improving our store productivity and by that, I mean that the revenue per store metric. Although our revenue per store has certainly improved over the last couple of years, as we've produced our consistent positive comp, we still feel that there's significant potential to improve the revenue output on a per-store basis. And we're going to -- to do that we're going to be looking at the work required and the investment required in our existing store footprints, and whether it's real estate refurbishment or improving and investing more in store personal training, deploying a technology that will improve the overall efficiency and speed within the stores, as well as ensuring that our merchandise assortment within our stores has been fine-tuned to meet the local needs of the environment. We believe there's much to be done to improve the revenue per store aspect, along with the top line initiatives, where we also will be focusing on maximizing our gross profit.

During the past several years, where we were dealing with commodity price increases, our goal with the gross margin rate was to maintain consistent, flat gross margin rate. But now we're focused on looking at our overall sourcing and supply chains, which is by far our largest expense, to really ensure that we have the most effective and cost-efficient relationship and frameworks with the entire supply chain in our business. And that's a process that we'll be going through over the next several quarters that we believe has opportunity for economic improvement for the company. Along with that, we'll be maintaining a very disciplined approach in the marketplace in terms of our promotional strategy in order to ensure that we maximize the gross margin side of our business. On the SG&A piece, because much of our growth is going to be coming from same store comp growth, we should see very favorable leverage rates as that revenue grows on the SG&A cost structure. We'll continue to watch our corporate cost very closely, and while we'll make investments, we'll make investments in future growth that will create some lumpiness in our overall SG&A expenses. We'll ensure those investments are made with a very robust return framework in terms of asset return and return on income.

And then, finally, while I believe the majority of the closed store activity is behind the company, we will continue to prune the fleet every year and look for stores where it may make sense economically to eliminate the costs, to redeploy the inventory, and we do expect to make a modest amount of store closures over the next couple of years. So these are really the keys to the foundation of profitable growth that go well beyond 2013. Many of these areas were part of what's allowed us to go from a significant loss to what we expect to be a positive profit in 2013, but they'll be enhanced and refined in a manner that should allow us to then even further accelerate net income growth into the future years.

So in conclusion, as Matt started out talking to you about the 3-year journey that we started a number of years ago, our first focus was to take a company with negative comps with a significant loss into a breakeven or profitable situation in 2013, and that milestone is now in sight, and the work that we've done, the progress we've made, has given us confidence that we can win in the marketplace. We can win in the marketplace both with our customers and within the investment community. We believe the best opportunity for this company is still in front of us, and we look forward to finishing off a strong 2013 and moving into the years ahead. Thank you very much.

Question-and-Answer Session

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Thank you both. Just wanted to kick off the questions with a general macro question. What are you seeing in terms of the health of the U.S. consumer? And have you seen any changes? I know you've mentioned on your conference call that your quarter was off to a bit of a difficult start. What do you attribute that to?

Matthew W. Appel

So we think the environment in the U.S. still can be affected by macroeconomic conditions. We certainly believe that the payroll tax increase that was implemented toward the end of January had a major effect on our business in the early part of February, I think, to a lesser extent, but still very noticeable, the delays in IRS refund checks had an impact on our early February sales. So I think when those types of things happen, they can still have and produce significant changes to the customer sentiment. Fortunately, as we talked about on the call on February 20, we were seeing the business stabilize as we went through Valentine's Day, and actually saw an improving trend as we got closer to the February 20 earnings date. So while the impact may have been sharp, potentially, it also may have been very temporary. And we'll have obviously more to say about our overall third quarter once we get into our earnings release schedule later this spring.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Great. And can you talk about some -- the performance of some of the newer exclusive products?

Thomas A. Haubenstricker

Sure. I'd be happy to. Microphone #1 is we don't know -- we were very pleased with the performance of our new exclusive products. Vera has performed very well for us. As I mentioned before, we're expanding it before Mother's Day. We're also testing men's bands and some other applications of the Vera name to really drive it as far as we can. The brand is very resilient. It's only been 1.5 years, and we're really taken it to a place that we're very pleased with. Celebration is a set of branded products, some of which we had before, but we completed the collection with the addition of the Celebration Fire, which is the best diamond in that collection, the diamond that I referred to as the most brilliant diamond in the world. A diamond that has passed some tests recently when subjected to them by the competition that -- well, I won't get into all of that right now, but it's a subject of litigation, if you're following that, at least, our advertising claim. I think the important thing here is that branded and proprietary products can bring not only greater loyalty, but higher margins, which is why we're so focused on taking them from 10% of the mix today to a minimum of 20% within 3 years.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

And then any learnings from products that maybe you've tried that hasn't worked out?

Matthew W. Appel

I can't think of anything significant that we tried that didn't work out. Seriously, testing is critical, which is why we're very, very rigorous around testing. When we first came into the turnaround period, we were anxious to get started, and we had 1 name brand that didn't work very well that we didn't test and that we withdrew. We're not doing that anymore. So we're going to start in 200 to 250 stores. We're going to test through 1 season or 2 and we're going to gracefully expand, not only the store count, but the SKU depth in an appropriate way. Our business turns one time a year, and you have to be patient in a business such as this. It'll take 2 or 3 years to build a branded program up to a full run rate.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Where are you on the product cost cycle? Will we see a benefit to gross margin from lower product cost this year?

Thomas A. Haubenstricker

So if you look at a year ago, we were sitting on a cost curve that was showing some pretty significant increases that we knew would work its way through our inventory. And so a year ago, our focus was really on price increases that we were going to have to pass onto the market in order to maintain our gross margin rate. Now what we see, if we look back the last 15 months, is stability in our supply chain. So we don't -- we're not seeing significant cost decreases, but we're certainly seeing none of the cost increases that have been in the past. As we mentioned, our focus is really now on looking at the effectiveness of our sourcing program. Much of the work that we did in our sourcing area was put in place 2010, 2011, and we were a different company financially then compared to what we are now. We're much stronger now. And we want to make sure, just like we did with the debt refinancing last summer, we want to really look at the whole framework of supply chain and sourcing and how we interact with that community and ensure that it's as efficient and effective as it should be for the Zale Corporation today.

Matthew W. Appel

It's not to suggest that our vendors haven't been very supportive. They've been great and they supported us at a time when we really needed the support. What we're talking about is examining such things as making versus buying so doing more assembly. We do about 20% of our -- we assemble about 20% of our product today, perhaps doing more assembly. There are duty implications, as well as other cost savings associated with that, and then the way in which we buy the inventory, whether it's a consignment versus actually buying it outright, return privileges, terms. There are lots of ways to benefit both the vendor community and our cost of goods while making the company stronger. So this is not about changing vendors. This is about just being sharper about the way we execute.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

And we'll see if anybody in the audience has a question.

Unknown Analyst

Just curious about the competitive disadvantage as you were working through the issues in the credit business relative to some of your peers. And where is that gap right now in terms of your credit conversion relative to what you would think your peers would be doing?

Matthew W. Appel

So with respect to credit, as you may know and others may know, we don't own our credit operations. This was a function that our predecessors decided to sell and we now offer on an outsourced basis. That's been going on for about 13 years. And so that, in and of itself, is a disadvantage as we can't control the credit granting process. Having said that, we've done a number of things to enhance, especially in the U.S., the availability of credit to our customers. The prime Citi program operates very effectively. We renewed it about 2 years ago, what we've done is put in place an alternative financing program that sits underneath Citi. Citi has the right to approve or decline any application that comes through. Once it's declined, we have a series of lenders, who consider that loan either on an installment basis, so a onetime transaction or we now offer something new. We have a gem, what we call a gems program, which is an installment basis, which is in many ways more attractive for both our customer as well as us because it creates a renewable hope in the buy like the Prime program, and so just above -- between 35% and 40% of our U.S. customers are taking advantage of this group of programs. And stronger than it has been, perhaps, not quite as strong as if we were controlling the lending decision, but we're very pleased with the progress we've made here.

Unknown Analyst

Just wondering if -- you had mentioned the improvement that you saw at the end of February, I assume, some of the tax refunds that have moved in. Did that improvement continue into March?

Thomas A. Haubenstricker

So obviously, we really can't talk about the business beyond what we said on the call. So all we really can do is reiterate the weak start to the month, the stabilization through Valentines, and then improving up till the February 20, but we really can't get into more information until we talk about the third quarter as a whole. We definitely believe that what affected us in the first week of February was externally driven from some of the tax changes. So that was clearly our thought that what caused that was more external and not something inherent within our business model.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Let me follow-up on something you said about investments. I know for the long-term mostly, but can you talk a little bit about second half SG&A, what we should expect there, and then maybe how that rate will trend over the longer term?

Matthew W. Appel

Sure. So when we look at the SG&A, the overall SG&A spending levels for the second half, we would see the pattern being very close to what we saw in the first half, where I think our absolute SG&A dollars were up about $3 million or so versus the first half last year. And I would expect that pattern to be the same in the second half, somewhere between flat to up a couple of million dollars. We -- as I mentioned, we're very focused on every quarter being able to deliver financial improvement and progress, but we're also very mindful that there are still investments that we need to make. When I talked about store productivity, we know that there are barriers today in our revenue per store around some of the more modest investments that have been made over the last couple of years in technology and in store personnel training, and to really get to what we think is our potential in terms of revenue per store, which will drive, obviously, better financial performance. We need to make those investments. So every quarter is going to be a blend of seeing some improvement in our core financials, but also understanding that we're investing for the long term.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

You mentioned repair as one of your initiatives. Is this something you're doing in-house or is this -- how do you plan to manage that business?

Matthew W. Appel

The repair business is a combination of in-house and outsourced. We do a fair amount of the work ourselves in our Dallas distribution center where we have assembly and ring sizing operations, but we also leverage a network of regional repair centers that are third parties, who have passed our rigorous test in terms of quality and turnaround time. But what we're also doing is putting in technology that will enable a better visibility to a customers' piece so that the customer and the store can also track it. We've simplified pricing and code so -- and we are training our jewelry consultants to better identify repair opportunities and to better realize revenues in that regard. So it's kind of a wide-ranging array of improvements that we're bringing in ring, but repair is very important to a full-service jeweler. Whether it's a watch battery or ring sizing or the tightening of prongs on a ring, our customers expect us to be able to maintain their jewelry over the course of a lifetime, and of course, we sell lifetime warranties so we need to be able to maintain and perform under those contracts as well and essentially repair as well.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Can you talk about the promotional environment in both the U.S. and in Canada? Has it eased at all since the holiday in either market and what are your expectations going forward?

Matthew W. Appel

Sure. We didn't really see any changes in the promotional environment in the U.S. during the past season. And as Tom already mentioned, we're very rigorous around maintaining our promotional discipline and extracting the margins that we expected during that period. Canada is a little tougher. There's a lot more promotional activity there that we had to address over the holiday period, and we'll continue to keep our eye on that, see what's required, but in the U.S., no great concerns.

Thomas A. Haubenstricker

We are seeing that customer buying patterns are changing if we looked at this past holiday versus holidays of the past in terms of the peaks that you see coming on and going into Black Friday, how quickly that changes and then the peaks that you'll see right before the Christmas period. So we definitely can see a change in those patterns, and what our focus is now is how do we optimize from a marketing, from a promotional cadence standpoint, what we see as these pattern differences. And you also can see when the online buying is the heaviest and when that tails off and the mall traffic picks up. So there's certainly things that we can digest and use to, as I said, to optimize our own performance and our own promotional strategy in future holiday periods.

Unknown Analyst

Can you talk about the real estate strategy? You mentioned closing a modest number of underperforming stores. I think that number of closures has been ramping down. Is there -- are there openings coming down the line?

Matthew W. Appel

Sure. In terms of the real estate strategy, it really can be characterized as the way -- in the way that Tom spoke about before, and that is driving increased productivity in the existing stores. We think that that's a much fruitful effort and much more beneficial place for us to invest capital than in new store openings. Store closings in the future will be modest, as Tom also mentioned, but there will be selective openings where the opportunities are unique and we do have a few on tap, but they certainly don't offset the number of closings that we've talked about for this year. I think it's not so much how many stores you have, but how well they perform. And so every time we close a store, we're looking at an accretive situation both to reclaim the inventory and put it to more productive use, but also to drive better performance in the remaining stores.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

When you've thought about the Gordon's brand and given how many -- how significant the marketing spend is for Zale, could you roll some of those Gordon's stores under the Zale nameplate?

Matthew W. Appel

Sure. With respect to Gordon's, maybe I could characterize the answer in terms of regional brands. Now everybody seems to be treating those. Clearly, the focus, not only within Zale, but within our principal competitors, has been on national brands, where advertising spends can be best leveraged, and you have -- you rightly identify a fact that Gordon's a bit -- quite a bit smaller than it used to be. We continue to look at measured contraction of that brand, but Gordon's does quite well in its home base of Texas and Oklahoma, where there's a very high concentration of stores. So Gordon's is not going away, but now we'll be very selective about it because we don't -- we're not able to well-leverage the national spend.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Okay. And then maybe just before we run out of time, a quick update on your e-commerce strategy.

Matthew W. Appel

Sure. Our e-commerce strategy is relatively unchanged. We've been very strong in this regard for quite a number of years, double-digit comps are the order of business. It's more about leveraging e-commerce into the full Omni-Channel model. So Ship-to-Store, social media, it's having that full experience for the guests whenever and wherever they want it. As it morphs to mobile, it's very important that we're able to provide access to e-commerce and our catalog, if you will, to our guests in a mobile environment. We've done a considerable amount of work there, and we will continue to do so to invest, but high ticket purchases are going to be made predominantly in stores, and so we see our e-store as a place for our guests to get comfortable with our selection, maybe to apply for credit, and for higher ticket purchases probably come to the store for lower ticket, either purchase it online or ship it to a store, where they can pick it up and where we can also perhaps add a warranty or some merchandise as an add-on to the sale.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Great. Well, I think, with that, we're out of time. So thanks very much.

Matthew W. Appel

Thank you, Lorraine.

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