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Executives

Neal Goldberg – President & CEO

Cynthia Gordon – SVP & Interim CFO

David Sternblitz – VP & Treasurer

Analysts

Lorraine Hutchinson – Banc of America/Merrill Lynch

William Armstrong - CL King & Associates

David Mann - Johnson Rice and Company

Chia Kuo – Telsey Advisory Group

Zale Corporation (ZLC) Q3 2009 Earnings Call May 27, 2009 9:00 AM ET

Operator

Good morning. At this time, I would like to welcome everyone to the Zale Corporation third quarter fiscal 2009 earnings release conference call. (Operator Instructions) I would now like to turn today’s conference over to Mr. David Sternblitz, Vice President, and Treasurer; please go ahead sir.

David Sternblitz

Good morning and thank you for joining us for our third quarter 2009 conference call. I am David Sternblitz, Vice President, and Treasurer of Zale.

With me on the call today are Neal Goldberg, Chief Executive Officer; Cynthia Gordon, Senior Vice President, Controller and Interim CFO; Theo Killion, President; Gil Hollander, Executive Vice President and Chief Sourcing and Supply Chain Officer; William Acevedo, Executive Vice President and Chief Stores Officer; and Mary Kwan, Executive Vice President and Chief Merchandising Officer.

Before I begin, I'd like to review the Safe Harbor. Our commentary and responses to your questions on this conference call will contain forward-looking statements, including statements relating to the future goals, plans, and objectives. These forward-looking statements are not guarantees of future performance, and a variety of factors could cause 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 statements is available in our Annual Report on Form 10-K for the year ended July 31, 2008 and our Quarterly Report on Form 10-Q, for the quarter ended January 31, 2009.

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 today's earnings release, which can be found on our corporate website, www.zalecorp.com, under the Shareholder Information tab.

I would now like to turn the call over to Neal.

Neal Goldberg

Thank you David, today I’d like to briefly review our third quarter results and talk about where we are as we prepare to finish fiscal 2009.

Our key goals coming into the quarter were twofold, one strengthen and stabilize the foundation of the business while two, starting to recapture the gross margin we lost from our promotional stance during holiday.

We accomplished these goals as gross margin returned to above 50% without a significant drop in same store sales trends from the second quarter 2009. We generated positive free cash flow for the period with debt levels being reduced to approximately $60 million from the second quarter.

The Valentine’s Day period was stronger then the remainder of the quarter. The comp decline in Q3 was against last year’s increase of 5.8%. As you will recall in March of 2008 we launched an aggressive clearance strategy to permanently liquidate $100 million of non-go forward merchandise.

While highly successful in allowing us to reach our goal of liquidating inventory, the clearance initiative does distort current performance due to the traffic and comp store sales increases in the prior year. We estimate after analyzing the trends that the clearance initiative drove approximately 10 percentage points in comp performance in the third quarter of last year.

While clearance was 30% of total sales during March and April last year, and drove significant volume it also compressed gross margins. For the third quarter gross margins increased 610 basis points for the holiday quarter reflecting the initial down payment on recapturing gross margin from our key item promotional strategy.

Most importantly we continue to expect 50% plus gross margins going forward. However, we are up against very difficult same store sales comparisons due to the aforementioned clearance initiative through September, 2009.

We continue to aggressively manage cash and capital expenditures and we expect to have positive free cash flow for the back half of our fiscal year. Additionally we now believe that debt levels can be reduced to approximately $330 million from the previously announced $350 million at year-end. We believe we have more then adequate liquidity to meet our foreseeable needs.

As you all have seen today we also announced Matthew Appel as our new Chief Financial Officer. Matthew comes to us very highly regarded. His broad range of experience in growth and turnaround companies make him a great complement to our team. He is an experienced operator with strong leadership and technical skills combined with deep expertise in strategic financial management.

Matthew will be integral as we capitalize on the opportunities ahead as well as intensify the financial rigor and discipline we have brought to the business. I would like to thank Cynthia Gordon who has served capably as our interim CFO, in addition to her ongoing role as Senior Vice President and Controller. She has been and continues to be an important asset to our team.

Before going any further, I’d like to step back and look at what we set out to do over the last year and a half to strengthen the company’s foundation. The strategies we implemented were done because they were right for the business, not because of environment. We are glad we started early in creating a more efficient business model.

We announced plans to permanently reduce inventory levels by $100 million, followed by an additional $75 million through better allocation and store closures. In order to create a more streamlined organization and address infrastructure costs that outpaced sales growth since 2002, we announced plans to create $130 million in expense savings through fiscal 2010.

As we continue with our financial rigor we are constantly looking for additional efficiencies in the business. The result is a stronger, leaner organization that is better equipped to connect with our customers.

A year ago we introduced our proprietary Diamond Celebration as we focused on private brands and being the best in diamonds. Celebration brought a differentiated look to our bridal assortment which is the cornerstone of our business. Similar to Celebration product rollouts take significant time. The process includes development, incubation, testing, product launch strategy, marketing, and store operations training.

Ideally the process requires an approximate six-month lead-time which means the execution for holiday begins in the spring. Our head merchant, Mary Kwan was hired in August, 2008. Post holiday a number of changes were made. She realigned and strengthened the merchandise and organization with inventory allocation and productivity as a focal point.

She implemented a fully integrated merchandise calendar to allow for the identification of trends, the development of more comprehensive product launches, and a more robust test in process. Unlike last year where we tested only specific items, this year our focus is set around testing big ideas as well.

We believe there is significant opportunity to increase our merchandise collections that create an emotional story especially during key selling periods. During Mother’s Day, we leveraged this new process and gained significant learnings. As a result we have identified two to three big programs which we have substantial potential for the entire fleet and that we intend to roll out for holiday.

As I have said many times, this is a marathon not a sprint. We believe today as we believed a year ago in the three major components of our strategy. One, focus on our value-oriented customer with differentiated distinctive product. Two, enhance our operational effectiveness and three, maintain financial rigor.

However, given the challenges in the fall cash flow, liquidity, and improving gross margins are more important then ever. The changes we are making to the model are even more critical now as we take actions to continue to strengthen the company’s foundation. We still have more work to do.

With only 10% to 15% of the company’s leases coming up for renewal each year, it is critical that we accelerate the right sizing of the business. We mentioned last quarter that we were in the midst of a detailed review of every store in our real estate portfolio. We engaged RCS real estate advisors to assist in developing our plan and negotiating on our behalf with our landlord partners.

We think the real estate opportunity is significant as we rationalize the size and scale of the company’s footprint and build a sustainable model that returns us to profitability. Our focus is squarely on generating the appropriate return on capital for each and every store.

As part of that we are looking to realign our rent structure with sales trends, close additional underperforming stores, renew leases that offer the best returns and successfully negotiate and efficient exit from our Bailey Banks & Biddle contingent liability.

While we have made very significant progress regarding our negotiations, we are not ready to discuss the financial details of the review. We look forward to sharing these details with you in the very near term.

We have a highly tendered team and I am proud of the accomplishments both in the field and our store support center. Without the dedication and commitment from all of our employees the actions we’ve taken to stabilize the business would not have been possible. Our people are the backbone of the company.

We will continue to support our associates through and increase in product knowledge and selling training that will improve execution. In this difficult retail environment our associates understand the importance of every customer interaction, just as critical as building a go forward business model that will return us to profitability.

I am confident our entire organization understands this and we have taken important steps to ensure that the business is not only positioned to survive the current economic environment, but also to capitalize on any improvements.

In closing we are making the proper adjustments to ensure our sound financial position without sacrificing the long-term. We have implemented the necessary changes and taken steps to strengthen the company’s foundation.

I would now like to turn the call over to Cynthia.

Cynthia Gordon

Thanks Neal, and good morning everyone. My comments will relate primarily to the financial results of the third quarter, the impact of our inventory and cost reduction initiatives, liquidity, and the additional steps we are taking to correct the business model.

First, financial results for the third quarter, total revenues were $379 million compared to $477 million for the prior year, a decrease of 20.5% for the third quarter. The reported revenue reflects a $2.7 million increase in recognized warranty revenues. These increases should continue as the accounting normalizes over the next year or two and revenues recognized more closely reflect actual warranty sales.

Total sales of warranty products were $21 million in the third quarter of 2009 compared to $28 million in 2008, a 26% decrease. The attachment rate was 49% as compared to 54% last year. We believe the decline in attachment rate is the byproduct of the decline in clearance as a percent of the business.

Comparable store sales decreased 20% compared to a 5.8% increase last year. While comparable store sales results are consistent with the second quarter, the two-year comparisons did improve this quarter from down approximately 25% in our second quarter to down 14% in our third, while margins returned to above 50%.

As Neal indicated, we believe our promotional stance over holiday was too broad and cost us margin with minimal impact to sales. Gross margin as a percent of sales was 44% for the quarter ended January, 2009. Gross margin for the third quarter was 50.1% of sales or 610 basis points higher then the second quarter.

SG&A was approximately $210 million in the third quarter of 2209, down $22 million compared to the prior year. The decline in absolute SG&A dollars was primarily a result of the recognition of $19 million in cost savings from the expense reduction initiatives.

Operating loss for the quarter was $35.7 million compared to an operating loss of $21.9 million last year. The effective tax rate for the quarter was 38.4% versus 26.4% last year. For the year excluding the impact of discrete tax items related to the tax valuation allowance and impact of goodwill, our effective tax rate is approximately 36%.

The net loss from continuing operations for the quarter was $23.2 million or $0.73 per share compared to a net loss of $17.4 million or $0.42 per share last year. Net loss per share for this quarter was negatively impacted by approximately $0.17 as a result of the share count reduction of approximately 10 million.

The weighted average shares outstanding were approximately 32 million this year, down 10 million from the 42 million weighted average shares in the prior year. The decrease reflects the impact of 17.6 million shares repurchased during fiscal 2008.

We ended the quarter with 1,356 fine jewelry stores and 694 kiosks. We opened one store and closed 31. We opened no kiosks and closed seven.

Now a more detailed update on our inventory and cost reduction initiatives announced in February, 2008 and again in 2009. As a reminder in February, 2008 we announced the first phase of our plan to reduce expenses by $65 million with the majority being reductions in SG&A.

We announced another $65 million reduction plan for phase two this past February for a total of $130 million plus through 2010. As I noted earlier we realized $19 million of savings in our third quarter. Since implementation we have realized SG&A savings of $12 million in the back half of 2008, $8 million in the first quarter of 2009, $21 million in the second quarter of 2009, and $19 million in the third quarter of 2009 for a total of $60 million in SG&A.

Of the $130 million in total reductions there is an additional $10 million reduction primarily in cost of goods sold related to the distribution and centralized customer repair activities. In the back half of calendar 2008, $6 million was realized. However it was offset by our growth in promotional stance during the holiday.

And additional $3 million was realized in the third quarter, bringing our total savings combined to $69 million. As we mentioned last quarter our continued focus on financial rigor includes a total review of our lease portfolio. The task is rationalize the size and scale of the company with a focus on returning the financial model to one of profitability.

We are moving rapidly to address the store issue with our landlord partners. We expect to improve operating earnings by achieving rent reductions across a significant piece of the portfolio and by accelerating the closing where reductions do not result in sufficient profitability.

In addition to improving operating earnings, these stores will free up additional inventory to supplement holiday purchases and ultimately eliminate inventory investment in locations with insufficient returns.

By taking the portfolio approach we expect to negotiate release from potential obligation related to the Bailey Banks & Biddle leases assumed by Finlay. As Neal stated, we expect to give additional details as the result of these actions in the near future.

A few important notes on the balance sheet, merchandise inventory was $759 million versus $867 million last year, a decrease of $108 million due largely to the clearance strategy executed last year. Furthermore we were cash flow positive on negative earnings for the quarter.

We reduced debt by $57 million to end the quarter with a balance of $332.8 million. We expect debt at July 31 to be at or slightly below this level excluding the impact of our real estate strategy. We will continue to anniversary positive comparable store sales trends through August. We have built our own forecast around continued softness in sales but a return to gross margins of approximately 50%. We will continue to focus on strengthening the business prior to holiday.

We started a process in spring of 2008 that was accelerated in light of the macroeconomic trends and have resized our infrastructure and capital requirements accordingly. We have reduced non-productive inventory by over $100 million with another $75 million to go. These moves should allow debt levels to be at or near prior year fiscal end borrowings despite difficult financial performance.

We are addressing or store portfolio to improve current performance and position us for profitability in the future.

I would now like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Lorraine Hutchinson – Banc of America/Merrill Lynch

Lorraine Hutchinson – Banc of America/Merrill Lynch

Two questions please, first would you be able to quantify what comp you would need in order to be free cash flow positive in 2010 and second, you talked about getting incremental cost savings, I know you can’t provide details here but should we expect a similar magnitude reduction as the prior programs.

Cynthia Gordon

I’ll first comment on the comps, we believe we can be cash flow positive with single-digit negative comps in 2010. And as for the additional expense reductions, as we’ve said, we’ve identified $65 million plus a year ago, another $65 million this year for a total of $130 and as we continue financial rigor and the disciplines with everything that we do, we will continue to look for more reductions.

Operator

Your next question comes from the line of William Armstrong - CL King & Associates

William Armstrong - CL King & Associates

I guess for starters on the sales line can you break it down between traffic and average ticket as far as those trends went in the third quarter.

Cynthia Gordon

Yes, the most significant piece was traffic. The ticket was up slightly for the quarter.

William Armstrong - CL King & Associates

Okay, I know you can’t speak too specifically about the rent reductions, but just sort of generally are we looking at outright reductions in rent or perhaps restructuring the way it is to have a more variable component to the store rent through the year.

Cynthia Gordon

Again, its an entire portfolio review so both will play into it. There will be absolute reductions, in some stores there will be percent rent in stores that leads to reductions. There will be extensions. There will be, its an entire portfolio review. So everything is open for discussion.

Neal Goldberg

And again this is the first time we’ve ever taken this kind of stance of looking at it across the entire portfolio by our landlord and because of the amount of leases we have with each of them, it is a large undertaking and we think the partners we have in RCS and with the rigor that’s gone into it we will be happy to get back to everyone in the very short near term to discuss the results.

William Armstrong - CL King & Associates

And I missed a little bit of what you said in your prepared comments at the end regarding, did I hear you say that you were going to reduce inventory another $75 million.

Cynthia Gordon

Yes you did, in February we announced that we would take another $65 out of SG&A and another $75 out of inventory through the course of 2010.

William Armstrong - CL King & Associates

Through the course of fiscal 2010.

Cynthia Gordon

Yes.

William Armstrong - CL King & Associates

Okay, and then finally the store count, you opened one and closed 31, can you just break that down by concept, do you have that handy.

David Sternblitz

I’ll get that information to you offline.

Operator

Your next question comes from the line of David Mann - Johnson Rice and Company

David Mann - Johnson Rice and Company

I actually have a few questions, I know you had talked about a few big programs you identified for the holiday season through Mother’s Day, I was wondering if you could maybe just elaborate a little bit on the merchandise tests you had there and then also secondly just an update on the performance in terms of bridal versus non-bridal.

Neal Goldberg

I’m not going to comment on the exact items, but I will talk about that you know, I want to elaborate a little on what I said in my prepared comments. Last year we went across, we were phasing in what we would do in merchandising, one of the most important things last year for Mother’s Day is really to clear up the clutter in our cases to make a much more compelling offering.

We focused on improving our item assortments. When Mary came on board last fall, she had a lot of work of getting the merchandising organization focused and on target. And holiday, really around January we started working on [what are] and which is a shorter lead-time then we ordinarily would like on what would be the big ideas we wanted to test for Mother’s Day.

We had three major big collection type of big ideas. The results were tested at large groups of stores with different testing rigors even using broadcast in one of the collections and the results were very favorable on those collection testing and which we looked to enjoy to roll for the holiday season.

Your second question was bridal, non-bridal, the bridal business continues to be our strong part of our business. Its still the largest summary and something with Celebration again uniqueness we think we will continue to do very well on that. Again, with the rigor that Mary has placed in the merchandising area, its really the focus on how to make sure we have differentiation, how we make sure we use our expertise in diamonds.

Arguably we have sold the most diamonds of anybody in the world over the last 85 years and we’re using that expertise and sourcing as well as merchandising just to make sure we keep up with a differentiated assortment that’s priced very well and so far we’re pleased with what the assortment looks like.

Once we take the clearance noise out from last year which ends mid September we think we’ll start enjoying some positive success in bridal again, but from the mix point of view, its still the largest part of our mix.

Operator

Your final question comes from the line of Chia Kuo – Telsey Advisory Group

Chia Kuo – Telsey Advisory Group

Just wanted to get more color on the gross margin, did it hold pretty steady throughout the quarter and then do you see any potential upside above and beyond the 50% we saw this quarter going forward and then secondly, just on the real estate strategy, you had mentioned before that around 10% to 15% of the store base was either break-even or cash flow negative, is that still a fair statement and would you say that the goal is to eventually close all these stores.

Neal Goldberg

Yes, the margin did hold steady at the plus 50% through the quarter and we expect and our plans are to have it hold steady over 50% for the future. We do expect through better costing, through really going after these big ideas that Mary’s worked on with her team which are plus 50% gross margin programs, plus just better identification through our core product to get, eek out either better cost and better retails.

We expect margin, there is potential margin upside. From a real estate perspective, I’ll let Cynthia take that.

Cynthia Gordon

Yes, we have talked about 10% or so of the stores being either cash flow neutral or negative. I think that as far as whether we accelerate those closings, there is also the potential as we’ve said to have rent reduction, rent relief, to turn those stores to profitability and some of those stores would have been included in our previously announced closure plan.

So again its not one shoe fits all, we are looking at the portfolio as a whole and the model as a whole.

Neal Goldberg

And again, just to reiterate, our focus is squarely on general the appropriate return on capital for each and every store and looking at this whole real estate review, we’re looking to realign our rent structure with our sales trends, close additional underperforming stores, renew lease that offer the best returns. So it’s a focused fleet review strategy.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Neal Goldberg

So with that I wanted to thank all of our associates, shareholders, and vendors for their continued support. Have a great day. Thank you.

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Source: Zale Corporation F3Q09 (Qtr End 04/30/09) Earnings Call Transcript
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