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Executives

Roxane Barry – Director, IR

Matt Appel – EVP and CFO

Theo Killion – CEO

Analysts

Rick Patel – Banc of America/Merrill Lynch

Jeff Stein – Soleil Securities Group

David Wu – Telsey Advisory Group

Zale (ZLC) F1Q11 Earnings Call November 23, 2010 8:00 AM ET

Operator

Good morning. I would like to welcome everyone to Zale Corporation’s fiscal first quarter 2011 results conference call. [Operator Instructions.] I would now like to turn the call over to Roxane Barry, director of investor relations. Please go ahead.

Roxane Barry

Good morning and thank you for joining us for the Zale Corporation’s first quarter fiscal 2011 conference call. I'm Roxane Barry, director of investor relations. On the call today are Theo Killion, chief executive officer; and Matt Appel, executive vice president and chief financial officer.

Before we begin, I'll 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. 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 annual report on Form 10-K for the fiscal quarter ended July 31, 2010.

I will now turn the call over to Matt.

Matt Appel

Thank you Roxane, and good morning to everyone. Revenues for the quarter ended October 31, 2010 were $327 million, compared to $329 million for the same period in the prior year, a decrease of 0.7%. Comparable store sales decreased 1.1% compared to a decrease of 6.8% in the prior year.

The decrease in revenues is primarily due to year-over-year store closures, partially offset by an increase in revenues recognized on our lifetime and 12-month warranty programs. Gross margin for the quarter ended October 31, 2010 was 50.5% compared to 48.6% for the prior year period. The 190 basis point improvement in gross margin was primarily due to the higher level of warranty revenue recognized in the quarter.

SG&A expense for the quarter ended October 31, 2010 declined approximately $8 million, or 3.9%, to $195 million compared to $203 million in the fiscal 2010 period. The decline in SG&A expense was due to our continuing discipline around expense levels, including lower occupancy costs due to store closures, renegotiated rents, and lower professional fees. In the 2010 period, professional fees included costs related to the restatement of our financial statements.

Operating loss in the first quarter improved $15 million to a loss of $42 million, compared to $57 million in the prior year period. Operating margin for the quarter was -12.8% compared to -17.2% in the fiscal 2010 period. This improvement reflects the initial progress made with respect to our turnaround program.

During the first quarter, the Canadian dollar remained strong relative to the U.S. dollar, with an average exchange rate of $0.97. In the first quarter of last year, this rate stood at $0.93, therefore year-over-year the Canadian dollar was approximately 4% stronger. Impact on the 2010 quarter's earnings was not significant, as the rate differential almost equally impacted all P&L line items.

Interest expense for the first quarter was $55 million compared to $2 million in the prior year. As previously disclosed in our fiscal 2010 10-K, this quarter's interest expense includes a charge totaling $45.8 million, which resulted from the amendment to our senior secured term loan executed on September 24, 2010.

In accordance with the applicable accounting standards, the amendment was considered a significant modification, which required us to account for the costs of the amendment and the previously incurred unamortized costs on the term loan as an extinguishment. $30.6 million of this charge was non-cash in the first quarter of 2011.

Excluding the $45.8 million charge, interest expense increased $7.6 million from the prior year. This increase was attributable to the borrowing costs related to the senior secured term loan, and higher costs related to borrowings under the extended tranche of the revolving credit agreement.

Now, moving to income taxes. Keep in mind that we remain subject to the three-year cumulative loss rules in the U.S. Therefore, net operating losses generated are fully reserved for due to the uncertainty surrounding future recognition. In the first quarter of fiscal 2011 we recorded an income tax benefit of approximately $100,000 compared to an expense of $1.2 million in the comparable period last year.

The 2011 benefit is primarily attributable to losses during the quarter in Canada. For the full year we anticipate some income tax expense related to our earnings in Canada. We have exhausted U.S. net operating loss carrybacks at this time.

The net loss from continuing operations for the quarter ended October 31, 2010 was $97.2 million, or $3.03 per share, compared to a net loss from continuing operations of $59.7 million, or $1.87 per share for the fiscal 2010 period. Excluding the interest charge related to the term loan amendment, loss per share from continuing operations for the quarter would have been approximately $1.60.

We ended the first quarter with 1,218 fine jewelry stores and 673 kiosks, for a total of 1,891 retail locations compared to 1,251 fine jewelry stores and 683 kiosks, for a total of 1,934 locations in the prior quarter. During the quarter we opened one fine jewelry store and two kiosks and closed one fine jewelry store and one kiosk. In addition, we rebranded three existing in-line locations.

Now let's turn to the balance sheet. Inventory at October 31, 2010 was $834 million, compared to $902 million at the end of the first quarter of the prior year. The decrease of $68 million is due principally to reductions related to store closures and efficiencies achieved in our supply chain operations. As we enter the holiday selling season, inventories are at planned levels and reflect the full support of our vendor partners.

As of October 31, 2010, the company had total outstanding debt of $450 million, compared to $466 million as of October 31, 2009. This reflects the paydown of $11.25 million on September 24, 2010 when we amended the term loan. In addition to the term loan balance of $140 million, long-term debt included $310 million borrowed under the revolving credit facility.

The company's asset-backed revolving credit facility increases to $650 million during the holiday season to provide liquidity for holiday purchases. Total available borrowing capacity as of October 31, 2010 stood at approximately $208 million compared to $129 million of availability as of October 31, 2009, representing an increase of approximately $90 million.

As we announced previously, we've put in place long-term private label credit card programs in both the U.S. and Canada. These programs are positively impacting our business. In the U.S. during the first quarter, there was an increase of nearly 6% in the number of applications submitted per store, along with an increase of nearly 10% in the average credit sales ticket over the same period in the prior year. This has been accomplished in a credit environment characterized by continued regulatory and macroeconomic headwinds.

We're also very pleased with the performance of our new Canadian credit card program, which has been in place since July 1, 2010. Credit application volumes are up 62% year-over-year, and we are very pleased with the 460 basis point year-over-year improvement in approval rates. We are offering an attractive [inaudible] credit choices add value, convenience, and affordability for our customers.

In the U.S. we're offering a variety of no interest options. In Canada, TD has partnered with us to enhance our normal credit offerings during this holiday with a special no interest, no payments until 2012 program that launched in October and will continue through the end of December. We are pleased with the early feedback from our customers on the value they see from these highly competitive offerings.

As we enter the holiday selling season, we remain focused on our multi-year turnaround. The liquidity position of the business, in our opinion, is sufficient to fund our plans. We intend to strike the appropriate balance between sales and margin to allow us to continue to deliver gross margins above 50% to fuel the recovery of the business.

We will continue to maintain discipline in all areas of the business, with particular emphasis on inventory, expenses, and capital management. We look forward to reporting our holiday sales in January, and at this time I'd like to turn the call over to Theo.

Theo Killion

Thanks Matt, and good morning. The financial results that Matt just reviewed represent progress in the execution of our turnaround plan. On past calls I've talked about our back to basics strategy and our goal to have between 80-85% inventory investment in core product.

Since January, we've increased the core 15% to 75%, and we expect to reach our goal by the third quarter. Importantly, the core merchandise comped positively in October, with gold rings, solitaires, and watches joining bridal, men's, diamond wedding bands, and silver as categories that are performing well.

We've been focused and methodical in rebuilding these important businesses, and in doing so we've listened to what our customers have told us in focus groups by offering quality products at great prices. In each of our summaries we have lower opening price points than last year in order to offer greater accessibility to our brands.

I've also talked about brand differentiation as an important component of our turnaround plan. One of the best examples of the work that we've done in this area is in Canada, with our Peoples and Mappins brands. For the quarter, we saw year-over-year top line improvement which accelerated with arrival of new merchandise receipts in October.

We believe that the directional change in these businesses is the result of our collective efforts to restore the dominance of our Canadian brands. These efforts include adding people in merchandising, marketing, and planning and allocation who have Canada as their primary accountability; creating the position of vice president of stores for Canada; adding differentiated product to each brand; differentiating our Peoples and Mappins holiday catalogs; developing and executing a marketing strategy that uses television, direct mail, and newspaper in a way that speaks to the personalities of each brand; establishing regular merchant visits to the market; making important investments in Canadian diamonds in the categories of bridal, solitaires, and diamond fashion; and finally, on October 28 we launched peoplesjewelers.com web store. It's exceeded our expectations in online traffic and revenue as well as driving additional traffic to the stores. As with all of our other initiatives, we still have a lot of work to do, but we're encouraged by the early results of these efforts.

The next few weeks are all about executing at a high level during the holiday season. We completed our holiday floor set the week of October 23. Our stores reflect our commitment to the core merchandise assortment, with clear, understandable value propositions in all categories.

Our catalogs have differentiated products in each brand, and our television advertising, which began November 10 in Canada, and November 15 in the U.S., declares Zales as the diamond store in the U.S. and Peoples as the diamond store in Canada. This declaration is not only a return to our roots as a jewelry store, but is also aspirational as we return to basics and rebuild our core.

I'd like to thank our 13,000 associates for their hard work and sacrifice, and a very thank you to our customer facing teams in ecommerce, Piercing Pagoda, Zales, Zales Outlet, Gordon's, Peoples, and Mappins. We have a small window to deliver some big results, but we have every confidence that our field teams will make it happen.

Please take the time to visit our stores over the holiday season. We look forward to your feedback in January and will now take your questions.

Question-and-Answer Session

Operator

This concludes the formal portion of the conference call. A question and answer session will now be conducted. To ensure adequate time for all questions, we request that you please ask only one question with a brief followup question if necessary. Our first question comes from the line of Rick Patel with -Banc of America-Merrill Lynch.

Rick Patel – Banc of America/Merrill Lynch

Can you just give us a little bit more detail about your marketing plans for the holiday season? Do you intend to spend the most on TV, print, online? And how does this compare to last year?

Theo Killion

In the aggregate, we will spend more than we spent last year. We're continuing to increase our online presence in banner ads and overall the budget will be spent 75% on television. We've increased things like direct mail and newspaper in Canada, where those media mean a great deal more to our guests.

Rick Patel – Banc of America/Merrill Lynch

And then your gross margin goal has been to be above 50%, and you've done well on that so far, but I'm curious to know what's going on on the cost side of the equation. Are you beginning to pass along higher gold and diamond costs to your customers? And if so, how has that response been?

Matt Appel

We're not passing along the lion's share of the cost at this point. As you know, our inventory turn is approximately 1 time a year. We've been very creative, for example, where gold is prevalent in Pagoda, by substituting bonded product, which has gotten great acceptance from our customers.

Keep in mind also that gold is not a significant portion of our key products of diamond studs and solitaires, but the cost pressure is clearly there in gold. We're not going to take any action at this time, but we're going to reevaluate that post-holiday to see where gold settles out. It's gone up, it's come back a little bit, and we'll take action at that time.

With respect to diamonds, diamonds are a very dynamic market. Again, we buy ahead of time. We have inventory of diamonds that were purchased in 2010 and some before, and so we have a very effective way of averaging our diamond costs and adjusting quality levels to expectations. No price adjustments at this time. We'll look at diamonds as well in January in connection with market conditions.

Operator

Our next question comes from the line of Jeff Stein with Soleil Securities.

Jeff Stein – Soleil Securities Group

Matt, wondering if you could be a little more specific on the impact of the warranty benefit on your gross margin? And also what was the level of credit penetration in the U.S. in the first quarter this year versus last?

Matt Appel

As you know, on our lifetime warranty we amortize it over a five-year period, and so on a year-over-year basis we saw approximately $4.5 million more of amortization come through. The one thing I do want to point out is that we've seen a significant increase in the ramp up of the one-year warrantees that we sell in our Pagoda business, which didn't contribute significantly to our revenues a year ago, but contributed almost $1.5 million to warranty revenue this year. We've had great acceptance in Pagoda and we're very proud of that. So warrantees on an overall basis about $5 million more of revenue.

In terms of credit in the U.S. no significant changes with regard to the mix. Approval rates are down some. That reflects the economic conditions that I think everyone in retail is facing, in the economy. But Citi's been a great partner, especially post-renewal, and our credit stats are strong, and we expect them to get even stronger through the holiday season.

Jeff Stein – Soleil Securities Group

Okay, I just want to make sure I understand that. If warranty revenue was up about $5 million, would that suggest that your gross profits excluding the warranty would have been $5 million less? I'm just wondering does it pass through to 100% margin?

Matt Appel

It doesn't pass through 100%, but a significant portion of it passes through, so the way you're thinking about it is accurate directionally.

Jeff Stein – Soleil Securities Group

And final question, and maybe this is more for Theo, wondering - the charm bracelet category's been very hot. Pandora is just an extremely hot category right now, one of your competitors at the beginning [inaudible] carry a lookalike Pandora and I noticed on your website it doesn't seem that you guys have really been able to capitalize on this trend. Do you have any plans to do so?

Theo Killion

Yeah, a couple of things, Jeff. Thanks for the question. One is that we've had charms in our Pagoda business for five years and they're doing reasonably well. In fact, we have charm parties in Pagoda. Additionally, we have done a pretty extensive test in Canada and we're reading it closely and we've done a few tests here in the United States. A year ago, you may remember that we went after charms pretty heavily. We were probably ahead of the trend at that point, and as we look at the business right now we're going to walk before we run. Our focus is really on the core assortment and fixing that and getting that back to where it should be. We believe that when we get to that 80-85% level we'll get paid for our efforts, and then we can spend a lot more time looking at some of these kinds of businesses. We see charms all over the marketplace at lots of prices right now, so we will walk before we run.

Operator

Your next question comes from the line of David Wu with Telsey Advisory Group.

David Wu – Telsey Advisory Group

First, I was just wondering if you're still seeing a positive comp momentum in select core basics such as bridal wedding bands and silver assortments. And just secondly, if you could just talk about how markdowns trended during the quarter?

Theo Killion

Okay, we'll split that one. Let me talk about what's happening with the cores. I mentioned earlier not only have businesses that we talked about in the last quarter, like bridal, men's, diamond wedding bands, and silver, performed well in the last quarter, but solitaires joined the group in October and watches joined the group. Gold rings joined the group. Some of categories had more challenges in terms of dealing with inventory that was unproductive, so we expect those to start to make progress in the month of November going into December. But we've been reasonably pleased so far with the ability to get back into the inventory, the support by the vendors, and ultimately how they performed on a comp basis.

Matt Appel

Markdowns were less significant than in the prior year and on a comparative basis that added 75 basis points to our margin year-over-year - quarter one to quarter one last year.

Operator

Ladies and gentlemen, we have reached our allotted time for Q&A today. I will turn the conference back over to management for closing remarks.

Theo Killion

I'd like to once again invite each and every one of you to visit our stores over the holiday season. As I mentioned earlier our advertising began in Canada November 10 and November 15 here in the United States. I was looking at a Twitter comment yesterday and one of the comments was that our commercials were "sick." I called up my son, who told me that that was very high praise, having the Black Keys. So early anecdotal response has been positive, but we look forward to executing and we look forward to having your feedback in January on our call.

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