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Zale Corporation (NYSE:ZLC)

F3Q10 (Qtr End 30/04/10) Earnings Call Transcript

May 26, 2010 9:00 am ET

Executives

Steve Massanelli – SVP and Treasurer

Matt Appel – EVP and CFO

Theo Killion – President and Interim CEO

Analysts

Rick Patel – Banc of America

Bill Armstrong – C.L. King & Associates

Operator

Good morning. My name is Wess and I will be your conference operator today. At this time, I would like to welcome everyone to the Zale Corporation third quarter fiscal 2010 results conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions) Thank you. I’d now like to turn the conference over to Mr. Steve Massanelli, Senior Vice President and Treasurer. Please go ahead, sir.

Steve Massanelli

Good morning. Thank you for joining us for the Zale Corporation third quarter 2010 conference call. I am Steve Massanelli, Senior Vice President and Treasurer. On the call today are Theo Killion, President and Chief Executive Officer, and 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 in this conference call will contain forward-looking statements, including statements relating to our 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.

Additional information concerning other 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 January 31, 2010.

I will now turn the call over to Matt Appel.

Matt Appel

Thank you, Steve, and good morning to everyone. Revenues for the quarter ended April 30, 2010 were $360 million compared to $379 million for the same period in 2009, a decrease of 5.1% that is due principally to year-over-year store closures. Comparable store sales decreased 2.2% compared to a decrease of 20% in the prior year.

Gross margin for the third quarter was 50.8% compared to 50.1% for the third quarter of 2009. The 70 basis point improvement was the result of significantly lower promotional activity during the 2010 quarter. Excluding a $4 million charge related to certain slow moving inventory recorded in the third quarter of 2010, gross margin would have been 52%.

SG&A expenses for the third quarter were $194 million compared to $210 million in the 2009 period. The $16 million or 8% decrease is the result of our ongoing discipline around expense levels, principally relating to field and corporate payroll costs and rent reductions primarily due to closed stores.

Our operating loss for the third quarter was $22 million compared to an operating loss of $34 million in the 2009 period, an improvement of $12 million. Operating margin for the quarter was negative 6.2% compared to negative 9.0% in the 2009 period, an improvement of approximately 280 basis points compared to last year.

In the quarter ended April 30, 2010, we reported an income tax benefit of $12 million compared to a benefit of $17 million in the comparable period in 2009. The income tax benefit for the quarter ended April 30, 2010 was primarily attributable to additional net operating loss carry-backs identified and recognized during the quarter pursuant to the Business Assistance Act of 2009.

Our net loss for the third quarter ended April 30, 2010 was $12 million or $0.38 per share compared to a net loss of $20 million or $0.61 per share for the 2009 period. During the third quarter of 2010, the Canadian dollar remained strong relative to the US dollar, with an average exchange rate of $0.97. In the third quarter of 2009, this rate stood at $0.81.

Therefore, year-over-year, the Canadian dollar was approximately 20% stronger. However, in the third quarter of 2008, the rate was $0.99. So, on a two-year basis, there has been no real impact to our profitability as a result of currency. Year-over-year impact on contribution was under $1 million as all P&L line items are nearly equally impacted.

We ended the third quarter with 1,224 fine jewelry stores and 677 kiosks for a total of 1,901 retail locations compared to 1,356 fine jewelry stores and 694 kiosks for a total of 2,050 locations at the end of the third quarter of 2009. Accordingly, we have closed a net amount of 149 retail locations since April 30, 2009. During this quarter, we opened no new retail locations and closed a total of six.

Now let’s turn to the balance sheet. Inventory at April 30, 2010 was $693 million compared to $763 million at the end of the third quarter of 2009. The decrease of $70 million is primarily related to better management of store inventory levels, store closures, and reserves recorded related to slower moving inventory.

Capital expenditures for the third quarter totaled $2 million and totaled $11 million year-to-date. With the projects we have planned for the fourth quarter, we expect to spend approximately $15 million to $20 million for the full year. Long-term debt as of April 30, 2010 stood at $299 million compared to $333 million and $368 million as of April 30, 2009 and January 31, 2010 respectively.

As we disclosed on May 10, we entered into a new $150 million senior secured term loan and utilized the net proceeds after all fees and expenses of approximately $125 million to pay down the revolving credit facility. As a result, total indebtedness was $310 million as of May 10, 2010, consisting of the $150 million term loan and a $160 million borrowed under the revolving credit facility.

In addition, total available borrowing capacity as of May 10, 2010 was approximately $250 million. With the most recent appraisal of our inventory on which revolver borrowings are based reflected a moderation as rates are effectively unchanged.

With respect to the covenants on the term loan, I want to clarify a point that people might be confused about, minimum liquidity and how it relates to the similar covenant in our revolving credit facility. Minimum liquidity for the term loan is based on 100% of appraised inventory value less reserves plus 100% of credit card receivables.

In our revolving credit facility, the availability is based on 90% of appraised inventory value, reducing to 87.5% effective January 1, 2011, plus 85% of credit card receivables. And minimum availability is generally $50 million for the agreement. The difference between the term loan covenant threshold at $120 million to $135 million and the minimum availability threshold in the revolving credit facility, which is generally $50 million, is attributable to the use of 100% for the term loan covenant as compared to the lower percentages applied in the revolving credit facility.

Now I would like to communicate the interest impact of the financing agreements we reached on May 10, 2010. Note that these impacts have both cash and non-cash components. Interest expense will have four primary drivers. First, interest payable line’s outstanding indebtedness related to our amended asset-backed revolving credit facility. Borrowings under the facility related to the extended charge will bear interest at LIBOR plus 350 to 400 basis points depending on our average availability compared to 100 to 150 for the non-extended charge. This, of course, is a cash component of interest expense.

Second, we incurred debt issuance costs related to the revolving credit facility of $13 million. These costs will be amortized to interest expense over the four-year life of the agreement. As a result, interest expense will increase by $0.7 million during the remainder of fiscal 2010 and $3.3 million during fiscal 2011 related to these items. And these items, of course, are non-cash.

Third, we incurred debt issuance costs related to the term loan of $12.7 million. These costs will be amortized to interest expense over the five-year life of the loan. In addition, the warrants issued in connection with the term loan have a fair value of $21.3 million. The value of the warrants represented discount that will be amortized to interest expense over the five-year life of the loan. The amortization of both the debt issuance costs and the fair value of the warrants will increase interest expense by $0.9 million during the remainder of fiscal 2010 and $4.4 million in fiscal 2011. All of this is non-cash.

Finally, the term loan bears interest at 15%. 10% of this must be paid in cash, but we can elect to defer up to 5% of the interest by adding this amount to the principal balance of the loan. Interest expense on the term loan will be approximately $5 million for the remainder of fiscal 2010, of which $3.3 million would be paid in cash if we elect to defer the full 5%. For fiscal 2011, interest expense will be approximately $23 million, of which approximately $15 million will be paid in cash if we elect to defer the full 5%.

Our focus for the next two quarters will be to complete planning for holiday to ensure the deployment of our new capital in the most effective manner, and we fully intend to restore this business to the performance levels attained in the past and that we are capable of achieving.

I’d now like to provide a short update on the progress we’ve made on the US credit card program. We announced on May 3 that we had entered exclusive negotiations through May 31 with Citi to extend the present deal beyond its current expiration of March 2011. And as a result, the payment of $6 million related to the shortfall of an interim volume commitment had been deferred.

While we have made progress with Citi during the past several weeks, we have nothing definitive to report at this time. Our work in this area will carry into June and we expect to extend the exclusivity period into June. Rest assured that in no situation will we be with our proprietary credit for our US customers during the upcoming holiday season.

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

Theo Killion

Thank you, Matt, and good morning. While there are improvements in certain line items on our income statement, taken in the absolute, the results are better than a year ago, but not good enough overall. I do, however, believe that we have made progress in executing our turnaround plan.

In order to provide context to the progress that we are making, I need to begin with some very improvement decisions that needed to be made last December. After a core November, we stopped incoming shipments of merchandise. The result was that we were able to minimize exposure for our vendors while preserving our liquidity.

We also carefully managed payables in order to ensure the viability of the franchise while we executed the capital raise that we announced earlier this month. The reason why this context is important to the third quarter is because the result of shutting down the supply chain in December meant that we didn’t get a normalized slow merchandise until mid-April.

Over the four-day Valentine’s Day, President’s Day weekend, not only were we challenged from a merchandise standpoint, we also had significantly less media than a year ago. In the Zales brand alone, we eliminated radio, two direct mail pieces, a catalog, and had 11 fewer days of television advertising.

We were, however, able to deliver a 5.5% comp performance over the four-day period, which is attributed to the outstanding effort of our sales teams. They were able to sell what they had, not necessarily what they wanted or what they needed. We also made the decision during the third quarter to reduce our promotional activity and walk away from some events that drove volume.

Specifically, we eliminated 27 days of discounting the whole store, either at 10% off or 10% to 15% off. We are committed to a planful strategic sales promotion and marketing approach even though it may adversely affect top line in the short-term. I mentioned on our call earlier this month that I would share some more details of our plan today.

First, let me restate one of the critical foundation points of the plan. As you recall, Gil and his merchant team have been working with our planning and allocation team to fix the core assortment. Part of that work involves identifying holes in the assortment based on historical and competitive analysis.

The other part of the work involves planning the liquidation strategy for unproductive SKUs. We’ve made progress on the former and with the beginning stage of the latter. The unproductive SKUs are primarily non-core product, and we will liquidate it in a way that preserves our margin discipline.

It is important to know here that while the bulk of our third quarter receipts didn’t arrive until mid-April, our vendors work closely with us to ensure that we’ve got the depth and the breadth of merchandise that we needed. We have also worked with them to restore terms more in line with our historic norm. In June, we are holding a vendor summit here in Dallas in order to thank the vendor community for their support.

In addition to the work that Gil and his team did to evaluate five years of merchandising history, we also did a five-year look-back at our total business. What we found is that each year, as we collapsed a brand into the Zales brand, the brand quickly went from positive comp to negative. Over a three-year period, beginning in 2006, we systematically merged brands. First, Gordon’s into Zales, then Outlet into Gordon’s in Zales, and finally, Canada into Gordon’s, Zales and Outlet. We also homogenized the merchandise offering in those brands. The resulting sales and profit erosion was in part due to those decisions.

The two businesses that performed most consistently are Piercing Pagoda and Zales.com. The teams who managed those businesses have remained intact with the singular focus on increasing profitable results over time. While we are not returning to the siloed organization structure that we had in the past, we have made some changes that we believe will pay off for us, as we begin to restore individual brand identity.

They include dedicating people in merchandising, planning and allocation, and marketing to each of the brands; enhancing our daily reporting by brand; and organizing our monthly business reviews by brand in order to understand what’s working and what’s not. We are fortunate to have people in the company with deep institutional knowledge about the Zales, Gordon’s and Zales Outlet brands, and we are leveraging that knowledge in order to build our brand thesis for the future.

In June and July, our merchants will be in Canada in order to better understand our opportunity for differentiation there with our Mappins and Peoples brands. We will combine this information with historical performance in order to frame our direction for the two Canadian brands. We will be deliberate in our approach and involve only after we test and invest in both merchandising and marketing. There are a number of other elements of the plan, which I won’t go into today, because we are just beginning to execute them. As we make more progress, we will share those as well.

Before I close, I’d like to mention two other things. The first relates o Mother’s Day. Sales for the four-day period, Thursday through Sunday, were soft. However, our margins remained strong. Next week, we do a Mother’s Day hindsight, which will provide us with detailed analysis of our holiday results, which I will share with you on our fourth quarter call.

Finally, I’m happy to say, through the hard work of our ecommerce and IT teams, we were able to launch Pagoda.com earlier this month. Pagoda.com joined zales.com, zalesoutlet.com, and gordonsjewelers.com, as we continue to expand our presence online.

I’d now like to turn the call back over to Wess for questions.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from Rick Patel of Banc of America.

Rick Patel – Banc of America

Good morning, everyone.

Theo Killion

Good morning.

Rick Patel – Banc of America

Can you talk about which product lines were the most successful during the quarter? And as you think about your strategy over the next few quarters, what do you plan to do in order to build the momentum for those product lines? And second, can you provide some color on the types of products you plan to liquidate as part of your non-core assortment?

Theo Killion

Sure. Let me first talk about the sort of foundation point of the strategy, which is reinstating the core assortment. As you know, Rick, the core assortment in jewelry is 85% of the business. And part of the issue that we unearthed in February and in March was that as we went after collections, we eroded the core brands. So much of what Gil and the team have been doing is working again to build up the strength of our bridal assortment, and what we discovered during the time that we were looking at it was opening price points had been taken out of the assortments so that our core customer who has a household income of about $50,000 really didn’t have the opportunity to shop with us last holiday.

So, the answer to your question of what’s performing isn’t about collections as much as it is about opening price points and getting back into the bridal. The opening price points performed extremely well. As you know, we have the Shared Heart collection. The best part of that collection in terms of performance is silver. Silver overall is doing extremely well. And those are entry level price points. We will continue to work the entry level price points. We will continue to work on strengthening our bridal assortment as we go forward.

Rick Patel – Banc of America

And can you talk about your pricing strategy as we see higher gold and diamond costs versus last year? Are you passing along these changes to customers in order to maintain gross margins? And if so, by how much?

Theo Killion

We will – what you saw in the press release was a gross margin that represents what we believe is more in line with where we should be and the discipline that we will have. Before the inventory valuation that was taken, we were at 52 points. Our mix and our margins will continue to yield margins that will be well over 50%. So we will figure in things like gold and silver – not gold – yes, gold and diamonds as we go and continue to maintain that margin.

Rick Patel – Banc of America

Great. Thank you very much.

Theo Killion

Thank you.

Matt Appel

Thank you, Rick.

Operator

Your next question comes from Bill Armstrong of C.L. King & Associates.

Bill Armstrong – C.L. King & Associates

Good morning. I just want to maybe get flushed out a little bit your re-organization by brands. I know when Neil was here, he was big on eliminating the silos, and you did indicate that you are not going to re-silo, but it sounds like you are kind of rebuilding the organization by brand more. I was wondering if you could just flush that out. And will that increase overall headcount and the overall SG&A dollars going forward?

Theo Killion

We don’t expect to have material impact on overall SG&A. What we will do, however, and I’ll give you a specific example, in merchandising where we have a senior merchant. That senior merchant has associates that work for them. Each of those associates will have a specific focus on the individual brands so that they are digging into Gordon’s to see what’s working and what’s not working. They are digging into the Canadian brands to see what’s working and not working. We have a similar organizational structure that we’ve put in place in planning and allocation, and a similar organizational structure that we’ve put in place in marketing.

So, as they look at what’s working and what’s not working in those businesses, issues of merchandise that may be there that we have to work through over time, we have conversations on a weekly and on a month basis about what are we learning and we are going to do some test and invest, as I mentioned before, to see what we can do to slowly pull apart those businesses and give them some resonance again.

We know, for instance, that the Gordon’s brand has about 18% Hispanic customers, and that has certain implications for what the merchandise assortment should be. We know that in Canada, the customers primarily urban, 80% of the customers are urban. And that has certain impacts for what the brand should be in an outlet. It’s a female self purchaser with a higher income than our Zales brand. So, as we look at those things and get back in touch with not only our customers in general, but the specific nature of the customers in those brands. We think it will drive some decision-making. And just simply having the eyes on it and having the visibility from a management standpoint, we think, will start to evolve it over time and pay us off.

Matt Appel

Bill, to give you a little more color on SG&A, the disciplines that this company put in place over the last couple of years remain strong. We continue to focus very closely on managing costs. We have additional items that we are focusing on. But on an overall basis, on a net basis, the things that Theo was talking about should not add as we look for additional reductions to offset the additional selected areas in which we want to invest to drive the top-line.

Bill Armstrong – C.L. King & Associates

Will we see more advertising or marketing spend going forward, especially compared to the depressed levels of recent quarters?

Theo Killion

We are in the process of putting to bed our marketing plan. It’s a little premature to share that now. So, Bill, I will defer that until our next call, at which point we will have a fully flushed out plan for the all-important holiday season.

Bill Armstrong – C.L. King & Associates

Okay. And then on the income taxes, should we still be looking for essentially zero income taxes going forward or will there be more NOL or other items that you think might come up?

Matt Appel

Essentially zero, Bill. We have exhausted, we believe, the carry-back opportunities at this time. And so we should resume a normalized tax look, which would be basically no impact for the US and perhaps some slight tax related to our Canadian operations, but effectively flat.

Bill Armstrong – C.L. King & Associates

Okay. And of that $12 million benefit, is any of that cash?

Matt Appel

We’ve got a $12.8 million refund. So, yes, we didn’t receive the refund until the first business day of May. So it doesn’t show off in the balance sheet. But the provision – the benefit was booked in the third quarter.

Bill Armstrong – C.L. King & Associates

Got it. Okay, thank you.

Operator

(Operator instructions) Your next question is a follow-up from Rick Patel with Banc of America.

Rick Patel – Banc of America

Hi, just a follow-up question, just doing some housekeeping here with the model. Can you help us understand how we should expect your share count to change going forward as it relates to the warrants? Is there a certain level that net income has to be in order to trigger inclusion of the warrants? And if so, what is that threshold?

Matt Appel

Well, you have to make money in order for the warrants or options for that matter not to be anti-dilutive. But beyond that, it’s the simple treasury stock calculation that you would apply based on the market price right now. The warrants are – they are priced at – exercise [ph] price is $2. There is very little spread between that and our market value. But they are anti-dilutive because of the loss at this juncture. So you – for modeling purposes, you know how to do that calculation once they become dilutive.

Rick Patel – Banc of America

Yes. That’s helpful. And now that you have some financial flexibility, will you be looking to close even more unproductive stores, perhaps now you can get out in the middle of a lease as opposed to waiting till the end? And how should we expect your store base to change over time as we look out at the next couple quarters?

Theo Killion

What our intention is now is not to have store closing as part of our strategy. That won’t be part of anything that we do going forward. We are returning to a more normalized view of looking at leases as leases come due, making the kind of decisions that are in the best interest of us for the long-term based on the performance of the center or based on the performance of the brand. So closing stores is not part of our go-forward strategy. And in the short-term, store base should remain relatively the same.

Rick Patel – Banc of America

That’s helpful. Thanks, guys.

Operator

And ladies and gentlemen, we have reached the end of the allotted time for the Q&A today. I’ll turn the conference back to management for any closing remarks.

Steve Massanelli

Thank you, everyone, for your attendance today. We appreciate your interest in Zale. This concludes our call for this morning.

Operator

And ladies and gentlemen, that concludes the Zale Corporation third quarter fiscal 2010 results conference call. We appreciate your time. You may now disconnect.

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