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Executives

Steve Massanelli – Senior Vice President and Treasurer

Matt Appel - Chief Financial Officer

Theo Killion – Interim Chief Executive Officer

Analysts

Rick Patel – Bank of America

Jeff Stein - Soleil Securities

Bill Armstrong - CL King & Associates

Zale Corporation (ZLC) F2Q10 Earnings Call February 24, 2010 9:00 AM ET

Operator

Welcome everyone to the second quarter fiscal 2010 earnings conference call. (Operator Instructions) I would now like to turn the call over to Steve Massanelli, Senior Vice President and Treasurer. Please go ahead, Sir.

Steve Massanelli

Good morning. Thank you for joining us for the Zale Corporation’s second quarter 2010 conference call. I am Steve Massanelli, Senior Vice President and Treasurer. On the call today are Theo Killion, President and Interim Chief Executive Officer; Matt Appel, Executive Vice President and Chief Financial Officer.

Before we begin, I will read our Safe Harbor statement. Our commentary and responses to your questions on this conference call will contain forward-looking statements including statements relating to our future goals, plans, and objectives and our expectations with respect to obtaining liquidity. 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 result expressed in these forward-looking statements including the continuing difficulties in the financing markets.

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 quarterly report on form 10-Q for the fiscal quarter ended October 31, 2009.

I will now turn the call over to Matt.

Matt Appel

Thank you Steve and good morning to everyone. Revenues for the quarter ended January 31, 2010 were $582 million compared to $679 million for the same period in 2009, a decrease of 14.3%. Comparable store sales decreased 11.2% compared to a decrease of 18.1% in the prior year.

Gross margin for the second quarter was 49.8% compared to 44.0% for the second quarter of 2009. The 580 basis point improvement was the result of less promotional activity during the holiday selling season. Excluding a $9 million charge related to certain slow moving inventory, our gross margin would have been 51.3%.

SG&A expenses for the second quarter were $251 million compared to $291 million in the 2009 period. The $40 million or 14% decrease relates primarily to our initiatives to reduce expenses including store closures. In addition, during the second quarter we recorded a pre-tax charge of $27 million of which $23 million was non-cash related to the impairment of certain store property and equipment as well as costs related to real estate.

Operating loss for the second quarter was $3 million compared to a loss of $22 million in the 2009 period, an improvement of $18 million. Operating margin for the quarter was negative 0.6% compared to negative 3.2% in the 2009 period. Despite the decrease in revenue, operating leverage improved by approximately 260 basis points compared to last year reflecting our continued focus on controlling costs. The $27 million pre-tax charge reduced operating income by approximately 470 basis points relative to sales.

In the quarter ended January 31, 2010, we reported an income tax benefit of $12 million compared to tax expense of $7 million in the comparable period in 2009. The income tax benefit was attributable to a $17 million credit recorded as a result of recent tax law changes increasing the net operating loss carry back period to five years, partially offset by $5 million of tax expense related primarily to earnings from our Canadian operations.

Net earnings for the second quarter ended January 31, 2010 were $7 million or $0.21 per share compared to a net loss of $32 million or $1 per share for the 2009 period.

We ended the second quarter with 1,228 fine jewelry stores and 679 kiosks for a total of 1,907 retail locations compared to 1,386 fine jewelry stores and 701 kiosks for a total of 2,087 locations at the end of the second quarter of 2009. During the quarter we opened one new fine jewelry location in Canada and closed a total of 24. In addition we closed four kiosks during the quarter.

Now let’s turn to the balance sheet. Inventory at January 31, 2010 was $738 million compared to $848 million at the end of the second quarter of 2009. The decrease of $110 million is primarily related to the aggressive management of working capital and a reduced store count associated with our real estate realignment.

Capital expenditures for the second quarter totaled $4 million consistent with our annual target of $20 million. Long-term debt as of January 31, 2010 stood at $368 million compared to $390 million at the end of the second quarter 2009. Despite the performance of the business over the past year we have successfully managed our debt to a level that is $22 million lower than a year ago.

As of January 31, 2010 we had approximately $67 million of availability under our $500 million asset backed revolving credit facility. Note that over the past year appraisals that were influenced by prevailing market conditions and resulted in a loss of approximately 1,200 basis points from our advance rates. This has reduced our borrowing capacity at a time when we most need it to fuel the turnaround of the business.

Under the terms of our credit facility, we must maintain $50 million of borrowing availability or satisfy a minimum fixed charge coverage ratio of 1.1. We do not currently meet the fixed charge coverage ratio test. We closely manage our liquidity level to ensure we do not breach the $50 million threshold. However, we do need to replace the liquidity we have lost through declining advance rates and the performance of our business over the past year.

Accordingly, my primary focus over the next three months will be to strengthen our liquidity profile by attracting new capital to the business. In addition, we are focused on securing new proprietary credit card arrangements in both Canada and the United States to address the 2011 expirations of our arrangements with Citi.

In our press release this morning we announced the board had formed a committee of independent directors to review a wide range of financing alternatives which will be formally vetted through Peter J. Solomon Co. We expect the process to bring new liquidity to the business and to take approximately 2-3 months. Suffice it to say we will exhaustively explore all options to raise capital.

One final note on liquidity. There have been countless articles and blogs that have speculated about our financial condition and our future. We have great confidence in our ability to obtain the financing that we are seeking and that this process will result in an outcome that is in the best interest of all stakeholders. I would also like to emphasize we have paid our vendors and I would like to thank them for their patience.

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

Theo Killion

Thanks Matt. Good morning. I am not going to spend my time this morning talking about the second quarter results except to say they are unacceptable and they speak for themselves. What I will talk about today is the work we have been focused on for the last six weeks. I am proud to say that despite the distractions that Matt mentioned our management team, our stores and the support staff here in Dallas have been working on analyzing and fixing the business.

Under Gill Hollander’s leadership our merchants have been singularly focused on analyzing their businesses; not just last week or last month’s performance but performance for the last 4-5 years. They have evaluated each summary and SKU based on historic performance, turn, gross margin, breadth of assortment, product tiers and quality. They have also spent time in our direct competitor stores to understand and analyze their assortments, their product tiers and their quality.

What they have found is we have significant opportunity, particularly in our core assortment. Not by purchasing new, untested goods, but by going back into categories and price points that have sold for us in the past and that are currently being sold by our competitors. The marketing team, led by Rich Lennox, has looked at every catalog, booklet, brochure and insert that we have produced over the last five years. We have looked at content, quality, volume and distribution and they too have been studying what has been working at the competition.

Rich and Gill have used their combined learnings to begin to craft a sales promotion and marketing strategy that leverages what has worked in the past while also creating a price value proposition that recognizes the difficult realities of our core customer. Our customer has been particularly hard hit during the last two years. Therefore it is critical that the Zale’s brands are accessible, relevant and continue to be a part of the most significant celebrations in our customer’s lives.

The planning and allocation team which Matt leads has looked at our total inventory and has mapped out a plan that will over the next year allow us to reposition our inventory and allow Gill and his team to exploit the opportunities I talked about earlier. This is a methodical process that we will execute without sacrificing margins.

What I am describing is the kind of work that can be done in a business that turns one time in a year. It is not sexy. It is not in the moment and it takes time and hard work. It takes a ruthless dedication to continually refine the core assortment with an ongoing analytical rigor that is agnostic and unemotional, purchasing only those goods that sell or that we have tested and retested.

What I am describing is something that our competition, our vendors and many of our employees know. The jewelry business at its core is a simple business. If you execute the fundamentals well it can be very profitable. Before I close, just a couple of words about Valentine’s Day and President’s Day weekend. For the four day period Friday through Monday we were comp store positive with margins north of 50%, certainly encouraging but we know that we have a long way to go.

I would like to finish by also thanking our merchandise vendors for their patience and support. I would like to particularly thank the 13,000 employees who over a long period of time have stuck with the business, who have supported us, who have been loyal and who have sacrificed because they believe in the Zale brand. It is truly a pleasure to serve you.

We will now take calls.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Rick Patel – Bank of America.

Rick Patel – Bank of America

A question on your SG&A decline. Can you talk about how sustainable this level of SG&A is? Can you talk about marketing and some of the other investments you need to make this year in order to stay competitive and how should we think about SG&A going forward?

Matt Appel

Good morning and thanks for joining us today. The SG&A expense reductions are very sustainable. A year ago we set out a target for $65 million reduction which we have now achieved. The majority of that cost has come from stores we have closed and from other reductions we have taken. But the majority has come from closed stores. So we are very confident we can sustain it, that we haven’t taken excessive cuts to SG&A. Certainly as our business recovers we will thoughtfully and carefully add back SG&A where needed to support the regrowth of our business.

One of those areas includes marketing. In marketing where we have been careful about our spend we feel as if we are spending the right amount and that our marketing has been very effective. We are really focused on effectiveness and not quantity. So it is quality over quantity in terms of multi-channel, in terms of internet and we don’t think necessarily that TV bombardment is the path to success in marketing.

Theo Killion

One of the things as you know is there appears to be a stabilization in the mid tier jewelry business right now. We have seen that certainly in our direct competitors. The best way to be able to impact SG&A is to raise sales so that is a primary focus at this point.

Rick Patel – Bank of America

A question on store closures. Can you talk about the profile of the stores that actually closed during the quarter? How many more stores like that do you have in the fleet? Can you also talk about how many operating leases you have expiring within the next 12 months?

Theo Killion

The store closures in the second quarter were nominal; less than 30. We did open one store in Canada. I would like to note that because we do continue to open stores in markets that are performing well for us. The profile of those stores is consistent with the profile of the stores we closed previously. In terms of comp performance and four-wall contribution.

In the future we don’t have any significant store closures planned. We will continue to look at stores that are not performing and that we don’t expect to turn around. We don’t expect any significant store closures over the next 12 months.

As far as the number of leases that expire over the next 12 months I don’t believe it is a significant number because of the actions we took with our landlords over the last year included extensions on our ongoing leases. I don’t have that number in front of me but we will provide it to you separately. It is not significant.

Operator

The next question comes from the line of Jeff Stein - Soleil Securities.

Jeff Stein - Soleil Securities

Curious in terms of how much capital you think the company needs to raise just to have a cushion to get through the next 12 months?

Theo Killion

Good question. We are really not going to comment on the amount of capital that we intend to raise. We do want to create enough runway to get us comfortably through the next holiday season and through the recovery of the business that we are working very hard at. As far as the timing, amount, source of that capital we are not going to comment on that at this time. Expect that within 2-3 months we will complete the exercise and we will be able to talk openly about it.

Jeff Stein - Soleil Securities

Can you talk about merchandise receipts? Are your key vendors shipping to you currently?

Matt Appel

They are. Vendors have been extremely supportive. I know that Theo thanked them and that I thank them. I would like to take this opportunity to thank them again. It has been a very difficult period in terms of credit insurance and in the industry on an overall basis. Our vendors have supported us in a very big way. Shipments are ongoing. Orders have been placed. Terms have expanded. We are very, very comfortable with the way the trade is interacting with us at this point in time.

Theo Killion

One of the other things we have been doing over the last six weeks is meeting with our vendors. In fact we have people in here today and we are ordering goods. They have been spectacularly supportive. We have an advantage we think in having Gill Hollander in his job, as you know. He was responsible for sourcing before he took on the expanded role of merchandising for Zale and for Pagoda. Those relationships have maintained. Gill can talk about their factories in a deep and personal way because he has been there. He knows what their strengths and skills are and having him bridge that relationship as he has made this transition has been enormously helpful to us.

Jeff Stein - Soleil Securities

A question on Peoples and Piercing Pagoda. Can you talk about their performance separate and apart from Zale’s and Gordon’s and outlet over the holiday and whether or not on a 12 month trailing basis those businesses are cash flow positive?

Matt Appel

We don’t disclose separately the performance of our various divisions. I think everyone does know that those two divisions are ones that have performed quite well and have distinguished themselves in our portfolio. Beyond that we don’t comment.

Theo Killion

We would be remiss if we didn’t mention that we also have an e-commerce business that has been performing extremely well also and continues to.

Jeff Stein - Soleil Securities

Wondering if you can talk about how you intend to get to the right merchandise mix given the fact that your category only does turn one time a year. What percentage of your inventory would you consider to be kind of viable and what you want to run with on a go-forward basis? How long is it going to take you to get to the appropriate mix?

Matt Appel

The content of our inventory that we intend to work through is not significantly different than it is post any holiday season. Gill and his team have done a spectacular job of identifying what we want to work through and how we will work through it. We are going to work through it very carefully and thoughtfully to maintain the margin performance we have demonstrated we can deliver in this business. There will be no excessive clearance actions. Over time and certainly by the time we need to have inventory for the next holiday season we will have worked through a fair amount of it and we will be in good position to capitalize on holiday 2010.

Theo Killion

The process that I described that the merchants have been going through is one that in the level and detail that I described they haven’t done in quite awhile. What Gill did was give them the opportunity to go through their categories and their businesses and to look at where the voids were in their inventory and what the opportunities were. We have quantified some of those things and we can say they are substantial. One of the sort of themes that runs through it is opening price point and entry levels of brand. We think that makes sense particularly with the profile of our core customer. That process is ongoing. That is why the vendors have been here for the past couple of weeks to start to fill some of those holes. As Matt described we will judiciously get out of the inventory we think is unproductive without sacrificing margins.

Jeff Stein - Soleil Securities

Inventory levels, where are you planning to take them over the next 12 months? Do you believe you have enough depth and assortment in the stores to offer a compelling offering to your customers?

Matt Appel

Our inventory levels are sufficient at the present time. The reduction we have talked about has a lot to do with the stores we have closed over the past year. We will manage our working capital very carefully and we may see a very slight reduction in inventory but nothing out of the ordinary as we reposition it as we talked about in the answer to your last question. Inventories are fairly stable. It is just a matter of working through it in sort of the off season here to get to the next season. We are comfortable with our levels.

Operator

The next question comes from the line of Bill Armstrong - CL King & Associates.

Bill Armstrong - CL King & Associates

To follow-up on that a little bit, in the absences of advertising or any great degree of advertising and you are holding a lot on mark downs, how will you get customers back into the stores? How will you get the message out to customers to come into Zale?

Theo Killion

Absence of marketing would be an over-statement. We did market at Valentine’s Day. It was a little less than what we did a year ago but we had three days of advertising on the critical, desperation periods of three days right before Valentine’s Day. We think that worked well for us. As we think about planning Mother’s Day we will have a full arsenal at our disposal and booklets and inserts. We are looking at that very closely. Importantly one of the things we did on Valentine’s Day was we had 56 million impressions on the internet. We know that there is a high correlation between people who shop online and shop in our stores. When we did our hindsight with one of our stores one of the things that many of the regionals talked about was the fact people had researched online, called the store to make sure we had the inventory and had come in. That leverage between the internet and our stores we think is powerful and we will continue to increase our presence in internet advertising as well as more traditional media.

Bill Armstrong - CL King & Associates

Moving onto capital, is the potential sale of one or more divisions on the table? Is that a possibility as far as raising capital is concerned?

Matt Appel

We are not going to comment on any aspect of the capital raising including the possible sale of piece of our business at this time. We are just going to leave that and comment on it once our process is complete. We don’t have currently any plans currently to sell any parts of our business. So let me just be clear about that. We are going to comment more fully on the whole process once it is complete.

Bill Armstrong - CL King & Associates

On the P&L you had a $27.5 million in other charges. $23.3 million were the impairment. What was the remaining looks like $4.2 million?

Matt Appel

It is not significant so we won’t comment on it. We only call out the material items.

Operator

At this time I would like to turn the call back over to management for closing remarks.

Theo Killion

We would like to say again to our vendors, our associates and to the investors who have stuck with us that we do believe that we are positioned to get back into a game that is working in mid-tier jewelry. We know there is a fix for the business. On February 8-9 we met with our board of directors and we showed them a comprehensive approach to how we want to run the business and how we can approach it. The board of directors supports that. We are in the process of executing it right now. Thank you all very much.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Zale Corporation F2Q10 (Qtr End 01/31/10) Earnings Call Transcript
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