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Signet Jewelers Ltd. (NYSE:SIG)

Q2 2015 Earnings Conference Call

August 28, 2014 08:30 AM ET

Executives

James Grant- VP of IR

Mike Barnes - CEO

Mark Light - President and COO

Michele Santana - CFO

Analysts

Simeon Siegel - Nomura Securities

Lorraine Hutchinson - Bank of America-Merrill Lynch

Ike Boruchow - Sterne Agee

Oliver Chen - Citigroup

Dorothy Lakner - Topeka Capital Markets

Jeff Stein - Northcoast Research

Operator

Welcome to the Signet Jewelers Second Quarter Fiscal 2015 Results Conference Call. My name is Helen, and I will be your operator for today’s call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session.

I will now turn the call over to Mr. James Grant, Vice President of Investor Relations. Sir, you may begin.

James Grant

Good morning, and welcome to our second quarter fiscal 2015 earnings call. On our call today are Mike Barnes, CEO; Mark Light, President and Chief Operating Officer and Michele Santana, Chief Financial Officer. The presentation deck, we will be referencing, is available under the Investor section of our website signetjewelers.com.

During today’s presentation, we will in places discuss Signet’s business outlook and make certain forward-looking statements. Any statements that are not historical facts are subject to a number of risks and uncertainties and actual results may differ materially.

We urge you to read the risk factors cautionary language and other disclosures in the annual report on Form 10-K that was filed with the SEC on March 27, 2014 and the quarterly report on Form 10-Q that was filed with the SEC on June 3, 2014. We also draw your attention to Slide 2 in today’s presentation.

And now, I’ll turn the call over to Mike.

Mike Barnes

Thanks James, and good morning everybody. In the second quarter, we successfully closed the Zale acquisition, and we’re really excited as we continue to move forward with the integration process. I’ll go through some of the major accomplishments that we’ve achieved with our new division in a few minutes, but now that we’ve completed the acquisition, we’ve also made a few changes with regards to how we discuss the operating segments, which you’ll see as we move through this presentation.

In looking at the second quarter, we’re very pleased with our results and the achievements that we’ve made. For the quarter, comps at Signet increased by 4.8% all-in, and organic comps that is Signet comps without the Zale acquisition were up by 6.3%. From a division perspective, Sterling in the UK certainly by the way there. Based on channels, both our eCommerce and our outlets were particularly strong for us. And from a merchandise view, branded bridal, fashion diamonds, and watches, all performed well.

Signet delivered second quarter profit driven by the strong execution of our strategies. Organic operating income was $124.1 million, and that was up by $18.6 million or 17.6%. And organic earnings per share was a $1 and that was up by $0.16 or 19%. For the first four weeks of the third quarter, we have had a very positive start, most notably in Sterling and in the UK We remain very well prepared for the second half and especially for the all-important fourth quarter. Mark is going to discuss some of our initiatives for this important holiday selling season here in a few minutes.

Let’s take a look now at Signet’s second quarter sales performance by our new divisions and SEC operating segments as a result of the sale acquisition. Sterling’s second quarter total sales were $810.4 million, and that was up by $69.3 million or 9.4%. Same-store sales increased by 6.7%, a very strong number. Kay comps led the way with an extremely strong 8.1% increase, while Jared increased by 4.9%, and that’s also a great comp number. The success in Sterling was driven in part by 16.6% increase in eCommerce sales and a variety of branded and non-branded merchandise initiatives. In a few minutes, Mark is going to walk you through our product performance for each of our three major divisions being Sterling, Zale, and the UK. He will also discuss some future opportunities for new merchandise going forward.

The Zale division, which we owned only for the last two months of the quarter, delivered total sales of $247.5 million and had a comp decline of 0.9%. Our UK division’s second quarter total sales were $162.9 million, and that was up by $23.8 million or 17.1%. Same-store sales increased by 4.4% and eCommerce sales increased 61% in total. But to be fair, it was 43% in constant currency. So to put it into a more of a comp basis 43%, hey that’s still a great performance by the UK eCommerce division.

The UK increases were driven principally by the benefits of strategic moves we’ve taken around diamonds and gold base upon better understanding of our customers and the type of products, pricing, and promotions that they require. For the quarter, jewelry and watches increased and were led by branded programs including the Forever Diamond program and Michael Kors.

Signet sales growth was driven in part by eCommerce sales in total of $50.5 million, now that was an increase of 61.9% and that does include all three divisions’ eCommerce sales. So, it’s a non-comp number as it includes Zale as well, still a very, very strong performance. One of the important drivers of Q2 sales was the outlet channel. All remaining ultra outlet stores from the November 2012 acquisition had a store front change to Jared Vault in the second quarter or early in the third quarter. Dollowing the changes, sales improved dramatically.

Most Jared Vaults are not yet fully differentiated from the ultra outlets other than the store front, but additional merchandise distinctions are coming soon and as the benefits are even more apparent in the few stores where we have already reassorted the merchandise, we’re looking forward to the future of the other stores.

Part of the strong year-over-year performance by our outlets could be attributed to the improved positioning of these stores versus last year when the outlook portfolio was really early on in its conversion. That is to say that systems and some field operation initiatives were in place, but merchandising and marketing changes were not, and training of our new associates was still in progress. Now however, we see the many strong benefits of the changes that have been implemented as we drive to a very strong outlet business moving forward. This continues to be one of our powerful strategic initiatives.

Now, looking at our strategic diamond sourcing initiative, this initiative represents approximately 10% of the value of the entire diamond procurement year-to-date. It ensures that we have access to the diamond cuts our guests require so that we can execute our merchandise initiatives. In fact, of the allocations we’re getting, more diamonds are usable in our stores than we actually modeled originally, which is great, and it means we’re having to resell very little on the global market.

We have expanded our relationships with mining industry leaders such as Rio Tinto and we’ve added new companies as sources of supply as well. You’ll hear more about that in the future. Most importantly, the team behind this initiative is becoming a centralized center of excellence, supporting the needs of each of our divisions.

That concludes my remarks on the second quarter. In my last couple of slides here, I’d like to speak at somewhat higher level about the overall organization we’ve put in place and about the progress we’ve made so far around the Zale acquisition. I’m so excited that the management lineups that we now have, because of the team’s experience and the working relationships with each other and the commitment from the long term, it’s really a great team that we put together.

As you can see on this Slide, we realigned the management of our core business to fit the current and future needs of our company. This strategic realignment will help us to build a stronger organization of the future through people, purpose, and patch thereby allowing us to successfully execute our mission which is very simple, and that is to help our guests celebrate life and express love.

I’d like to think of our new transform organization in terms of one, three, eight. There’s been a lot of exciting changes which I believe will help to lead us to bigger and a brighter future. So, I’m sure you guys are wondering what those one, three, eight means. While, Signet is one great company, and within our company we have three very strong divisions called Sterling Jewelers, which includes both the Kay and Jared brands; the UK comprised primarily of H.Samuel and Ernest Jones; and Zale primarily comprised of Zale’s Piercing Pagoda in the U.S. and then Peoples in Canada. Those are seven incredible national brands with leading market shares and constitute leading market share in all three geographies not just one or two. We consider our eighth brand, which is also very powerful to be the combination of all the regional brands that we have within each division and country.

Now ultimately I’m responsible for all of this but on a more day-to-day basis. I will continue to spend time on corporate functions, support and strategy while our COO, Mark Light a 36 year veteran who knows the heart and the soul of the jewelry business better than anyone I know who are in the operations.

Mark leads the passionate management team which is work so well together. They’re all about team work and collaboration sharing best practices and delivering excellence. Mark and our three division leaders Ed Hrabak, who is newly promoted President of Sterling, Sebastian Hobbs our Managing Director in the UK and George Murray recently promoted to President of Sale have been leaders of teams that has consistently produced outstanding Signet results. They possessed deep understanding of their guests and each of the functional areas within their divisions. In a few moments, you’ll also hear from our new CFO, Michele Santana who I’m also very excited to have here and who I’m certainly enjoying working within the many years to come.

Now I’d like to turn the page and talk about the Zale acquisition and some of the accomplishments that we have made since the May 29th close. We put teams in place to identify the best approaches and opportunities for this integration. The cultural assimilation of the newly combined company is going extremely well. The teams are identifying value creating opportunities and they’ll continue to work together for at least another year. We are making so much progress that I now expect we will deliver a 150 million to 175 million in synergies from this acquisition for the first three years from January 2015 to January 2018.

As I’ve mentioned I could not be happier about the lineup that putting out on the field. First and foremost is about the people. There have been many changes among the Zale leadership team and there have been some modest changes at other levels in the Zale division but nothing unexpectedly disruptive. It’s been good change and again I’m extremely pleased with our reenergized and motivated team that’s ready to move forward in collaboration with all the remaining team members in our combined organization which by the way now numbers approximately 30,000 people strong.

In store operations, for the first time in over 10 years, we’re instituting a managers’ meeting which we call a leadership conference to gear up for the holiday selling season. Modeled after the incredibly successful event that Sterling does every year the Zale leadership conference will bring store managers and other store ups leadership together next month for a multiday conference to learn, practice and get energized about the holiday season strategy products and priorities.

Around procurement, we’ve started to centralize the diamond buying process. We are already seeing incremental savings as we put Signet best practices in place. Regarding merchandising, we are already testing the cross selling of certain collections some of the more high profile brands of Zale or testing in Kay and vice versa. We are leveraging Signet’s media relationships to enhance the media mix and exposure the Zale brands will receive for the 2014, 2015 year. And by combing our investments we’re seeing a net improvement in pricing for the entire company.

We are also leveraging capacity in our backend business model to drive greater effectiveness in cost savings in repair and custom design. In conclusion, as you can see we are making a tremendous amount of progress on this integration. I couldn’t be more excited about the position we’re in today and where we are headed. So with that I’ll now turn the call over to Signet President and Chief Operating Officer, Mark Light for some words about our Q2 and second half performance drivers.

Mark Light

Thank you Mike. We have variety of drivers behind our great Mother’s Day and second quarter. Most notably was due to our sustainable competitive strength that includes our superior customer experience, our exciting merchandise offerings, effective marketing and multichannel approach. The customer experience essential to our success and we remain focused on the training and development of our store teams in each of our three divisions. A good example of our training and development is our managements’ leadership conference that Mike just talked about. Now let me take a little time to talk about global business within each of our three divisions during the second quarter in both our branded and non-branded merchandise programs.

In our Sterling division our Le Vian and Neil Lane brands continued to do very well along with our colored diamond collection, Artistry and Vivid. In our UK division, the luxury and fashion watch brands continued to perform well along with our bridal diamond brands Forever and Perfect Fit in H. Samuel and Le Vian, Tolkowsky and Neil Lane in our Earnest Jones stores. In the Zale division, the Vera Wang Love Collection, Celebration Diamond Gemstones and the Arctic Brilliance Collection all did well. And an exciting new diamond setting technique is doing very well in all three of our divisions and our Sterling and UK divisions we call them Diamonds in Rhythm and in our sale division it’s called Unstoppable Love. Our marketing efforts generate strong financial returns led by Bridal and successful Mother’s Day programs specifically in our Sterling and UK divisions.

We also saw success across selling channels; eCommerce and outlet sales were up significantly. The eCommerce performance was driven impart by 37 million visitors to our sites and over 50% of them came through mobile devices.

As we look forward to the second half, we remain confident in our ability to deliver outstanding products rages that meet our guest desires. We have tested a variety of line extensions and new programs with strong results. These examples on slide 10 are among the exciting new collections for the second half. And by the way while still in early days of integration we have already worked with our team at Zale’s of some terrific new brand extension ideas for the future. More on that will be forthcoming as we get momentum behind these ideas and begin testing.

We are pleased to have started the association with the Smithsonian Institute. The Earthly Treasures Smithsonian collection is in select Jared stores and available online. It includes the sale on Blue Sapphire, London Blue Topaz, Sleeping Beauty Turquoise, Morganite, Sugilite, Great Garnet and Jade collection in approximately 60 styles and it’s only offered in our Jared stores. We also launched a new fashion for diamond gemstone and gold design collections inspired by Sofia Vergara’s sense of style. These pieces have both geometric looks to showcase movement and they fill features silver combined with rose and yellow gold along with all gold and all silver designs. These are being tested in our Kay stores.

This spring we expanded our Lois Hi collection and now her handmade collection has diamonds incorporated into some of her designs that are in all of our Jared doors. Additional opportunity is in the line extension of LOIS by Lois Hill, which is in our Kay stores. This collection presents the same DNA as the Jared collection but at price points and styles for the Kay guest. We plan to expand the collections to all Kay stores for this fall. Also within our Kay stores Lowe’s full bridal will be introduced and tested this fall. We also have other promising line extensions such as in our Neil Lane category we’re testing solitaires and men’s rings. And one opportunity with regards to the Zale acquisition around merchandise assortments involves non-productive inventory.

We will limit the slowest moving inventory for the holiday season making way for more desirable faster moving merchandise in those stores. We are confident we can improve inventory turns in our Zale division not only through inventory management size and merchandise initiatives but also through improving the productivity of our field operations, marketing and other areas that contribute to improve the store to productivity. We intend to use our outlet channel, vendor relationships and other techniques and chances to turn Zale’s inventory at a rate much closer to Sterling’s in the future.

We also have exciting new store concepts in various stages of testing or rollout. Importantly, all real estate be it Kay or Zale outlet or in close is all managed by a centralized best in class Signet team with consistent IRR expectations. A new generation of Kay stores is rolling out featuring more side by side selling, boutiques a consultation room and enhanced technology. Jared Vault stores are fully rolled out completing conversion of our acquired outlet stores.

Now a gradual merchandise transition is underway to distinguish these stores even more through Kay, Zale and other outlet competition. We’ve also launched five Pandora shopping shop locations within our Jared stores with a selling concert that mirrors Pandora stores.

In the era of eCommerce this probably have updated our mobile apps to complement our mobile and tablet optimized sites for both Kay and Jared brands within our Sterling division. We’ll also launch a digital influence campaign working with bloggers and other social media influences to reach new and expanded audiences. From a marketing perspective, in all three of our divisions, Kay and Jared in the Sterling division, Zale’s and People’s in the Zale division and H. Samuel in the UK division will be increasing TV advertising this fall and each of our divisions will have new TV creative which will help promote some of our new campaigns and promotions.

And now I’ll turn the call over to Michele for a run through on the financials.

Michele Santana

Thanks Mark and good morning everyone. So let’s start by reviewing second quarter sales. Mike had offered a similar overview of the numbers on slide four so I will just point out a few brief highlights. Starting with Sterling division, total sales increased 9.4% to $810.4 million which included a same store sales increase of 6.7%. Sales increases were driven by a balance between both the number of transactions and the average transaction price with the number of transactions increasing 5.8% and the average transaction price increasing 4.6%.

The average transaction price increase was driven principally by the mix effect of strong sales in high-tech brand such as Le Vian and Neil Lane. Zale division sales were $247.5 million for the quarter and that includes a $9.3 million unfavorable revenue impact due to purchase accounting adjustments. Under purchase accounting, Zale differed revenue was reduced on the opening balance sheet from a $183.8 million to $93 million resulting in a permanent reset of the associated revenue to be recognized.

This adjustment will continue, they have an unfavorable non-cash impact to Zale revenue over the next several years and will diminish thereafter and hopefully recognized over the estimated claim period. UK total sales increased 17.1% to $162.9 million driven primarily by Ernest Jones. Merchandised transactions in UK increased 4.8% and it was primarily due to higher sales of fashion watches and jewelry and more effective store of that. The average merchandised transaction values decline slightly by 0.9% and that’s primarily driven by sales mix.

Now moving on, over the next couple of slides we’ll look at Signet’s consolidated Q2 performance before we than discuss Signet’s organic results. Our second quarter results include the 65 days of performance of the Zale division. And looking at the year-over-year gross margin rate, SG&A ratio and operating margin, there is an unfavorable movement in these rates due to the acquisition of Zale.

Zale operates for the lower sort of productivity and a less efficient operating cost structure and so therefore present is diluted to Signet’s ratio. Nevertheless, the Zale operations were in line with internal forecast and more accretive to the quarter. Accounting adjustments primarily included a reduction of deferred revenue recognized in relation to expanded service plans, inventory fair value step up amortization as well as the amortization of unfavorable contracts which were all diluted to EPS by $0.10.

Other factors such as SGA rate, which by the way is substantially behind us as we move forward. Capital structure in financing and transaction cost also impacted EPS as outlined on slide 13. Income tax expense was 11.8 million with an effective tax rate of 16.9% for the quarter. The forecasted effective tax rate for fiscal 2015 is 29.3%, which is lower than the 35.1% applied as the first quarter. This reduction of 5.8% in Signet’s effective tax rate primarily reflect the benefit of Signet’s amended capital structure and financing arrangements utilized upon the acquisition of Zale.

This all led to reported earnings per share of $0.72 compared to prior year’s second quarter of $0.84. Next, I’ll walk you through the breakout of operating income by division. Operating income was $83.5 million or 6.8% of sales and that was made up of the following components: Sterling Jewelers operating income of $129.9 million or 16% of division sales, Zale division operating loss of $9.8 million or 4% of division sales.

Now that’s does include a loss of $11.5 million related to acquisition accounting adjustments which we just discussed on the previous slide. Excluding the impact on these accounting adjustments, Zale division’s operating income was $1.7 million or 0.7% of sales and when looking at the Zale division operating income of $1.7 million that consist of $1.4 million from the Zale jewelry operating segment and $0.3 million from the Piercing Pagoda operating segment. UK operating income was $1.1 million or 0.7% of division sales and other, which other consist primarily of our corporate administrative expenses and Signet’s diamond sourcing subsidiary was a lot of $37.7 million and that was principally driven by transaction and severance cost.

To give you better comparability to last year, I’ll share with you our results on our organic basis which exclude the Zale operation accounting adjustments and cost related capital structure and financing as well as severance and transaction cost. Organic gross margin was $340 million, an increase of $30.3 million with a gross margin rate of 34.8% down 40 basis points. This decrease was driven primarily by two factors in the UK division. The first being Signet’s strategic initiatives around diamond and gold program, which reduce the gross margin rate but importantly and successfully drove incremental gross margin dollar.

The second factor was a shift in merchandised mix as a result of strong watch sales. Organic SG&A was $269.6 million compare to $250.5 million in the prior year second quarter an increase of $19.1 million and as a percentage of sale decreased 90 basis points to 27.6%. And this was driven principally by greater sales leverage on store staff and centralized cost.

Other operating income was $53.7 million or 5.5% organic sales compared to $46.3 million or 5.3% of sales last year. This increase of $7.4 million was primarily driven by higher interest income earned from the higher outstanding receivable balances. Organic operating income in the second quarter was $124.1 million or 12.7% of sale an improvement of 70 basis points. Organic EPS was a $1 and that compares to $0.84 in the second quarter of fiscal 2014 and increase of 19%.

Now let’s turn to the balance sheet and I’ll start with inventory. Net inventories ended the quarter at $2.3 billion and that compares to $1.4 billion in the second quarter last year, an increase of $928 million or 65%. The majority of the increase was driven by the acquisition of Zale, a variety of merchandise initiatives in the sterling division, including branded program both new and expanded as well as new store growth.

U.K. inventory which increased in U.S. dollar due to the impact of foreign currency translation and being more vertically integrated by growing our rough diamond initiative. Then just to add a little bit more color on the biggest driver the addition of Zale inventory. The initial net fair value step up on the Zale inventory was approximately $31 million.

At the end of the second quarter, $27 million remain and that will continue to see recognize in the P&L based on inventory churn and will have the affect of reduction gross margins in Zale. The other item I would point out is that Zale inventory has now reported on a FIFO basis, which is consistent with Signet’s other division.

So let’s move on and discuss in house credit metrics and statistics. In-house credit remains an important component of sterling divisions business. Net accounts receivable increased to $1,316 million compared to $1,152.1 million last year and that’s up 14% driven by higher sales and an increase in the credit penetration rate.

In the year-to-date, credit participation was 60% compare to 57.1% last year. The increase in credit participation is attributed primarily to the credit decision engine improvements, higher outlet participation and strong guest acceptance of our credit offerings. We have recently invested in a new decision engine which preserve credit requirements but more accurately scores applicant which yields more qualified customers.

The average monthly collection rate year-to-date were 12.4% and that compares to 12.6% last year as guest continue to opt more for our regular credit turns which requires lower monthly payments as opposed to the 12 month interest rate program.

Next I’ll move on to credit statistics focusing on year-to-date metrics which minimizes the affect of seasonality. So on a year-to-date our net debt expense was $64.1 million compare to $57.8 million last year and increase to $6.3 million and this is driven primarily by the growth in the receivable balance from increased credit penetration and change in the credit program mix. Year-to-date other operating income was a $107.7 million compare to $93.3 million last year, an increase of $14.4 million and that’s due primarily to more interest income on a higher outstanding receivable as well as the shift away from interest fee program.

As a percentage of sterling division sales, other operating income in the year-to-date increased 6.3% of sale from 5.8% of sales last year. So the net impact of these two items was income of $43.6 million year-to-date compared to $35.5 million in the prior year, an increase of $8.1 million. Operating improvements made to our decision engine has help to increase credit penetration without adversely affecting the net impact of bad debt. The portfolio continues to perform strongly and that is evidenced by the allowance as a percentage of ending accounts receivable decreasing 20 basis points from 7.2% to 7%.

Let’s move on to some other highlights on the balance sheet. We now carry $1.4 billion of debt and this debt is very cost efficient at an average interest cost of 2.6%. The Zale acquisition was financed in such a way so as to really balance cost efficiency and end up with an appropriate mix of short, medium and long term debt.

As we continue forward, Signet is committed to maintaining an investment grade rating and the capital allocation strategy that provides for financial flexibility to allow execution of strategic priorities for growth including M&A, protection if a black swan event should arise optimization of Signet’s capital structure and cost to capital and return of excess free cash flow to shareholders in the form of share repurchases and dividends. We will remain disciplined but will also flex our capital structure as necessary based on the circumstances such as growth opportunities or economic condition. The Signet management team continue to have a shareholder friendly history that include share buyback, dividend increases, M&A and keeping reasonable cash reserves. We ended the quarter with cash of $215 million as we move into our third quarter, our heavy holiday buying period.

Now let me share with you our guidance. For the first time our guidance includes the acquisition and integration of Zale. Third quarter Signet comparable store sales are expected to increase 2% to 4%. Now underlying this guidance, we expect ongoing momentum in our Sterling and UK division and slightly positive comps, which should improve sequentially as we continue the work free integration and build to the holiday season. Third quarter adjusted EPS is expected to be $0.12 to $0.18. Adjusted EPS includes the organic EPS and EPS attributable to the Zale operations as well as the impact from capital structure and financing cost. So set differently, adjusted EPS include Signet in this entirety excluding purchase accounting adjustments and transaction cost.

Now as per these adjustments, purchase accounting adjustment including a deferred revenue impact of $0.10 are expected to be dilutive by $0.14 to $0.12. Transaction cost which primarily consist of integration expenses are expected to be dilutive by $0.09 to $0.07. And if I can just add two final thoughts in this quarter we adjusted EPS guidance. First Zale operations are expected to dilute third quarter EPS by $0.21 to $0.19, which Zale has historically reported losses in over quarter given the small volume in not giving period. And secondly while our adjusted EPS guidance may appear to be lower than last year’s third quarter results, this is really due to Zale and interest expense both embedded in our adjusted EPS guidance.

So apples-to-apples, we anticipate a better Q3 year-over-year and I’d be more than happy to walk you this further Q&A if need be. While we’re also introducing annual EPS guidance and therefore Q4 EPS guidance for the first time and on a one-time basis because of the complexity of modeling in this early stage of integration. Following guidance on this call, we expect to return to giving EPS guidance on a quarter-to-quarter basis.

The annual adjusted EPS projection is $5.38 to $5.54 but remain subject to revision later this year. Zale operations included within the adjusted EPS are expected to be accretive to fiscal 2015 by $0.18 to $0.24. And the annual effective tax rate is anticipated to be 29.3% for fiscal 2015. Capital expenditures guidance for the full year is now $240 million to $260 million up from our last earnings call and that is due to the eminent plan investments in Zale of approximately $55 million.

Looking at net selling square footage that’s projected to grow 45% to 47.5% including Zale or approximately 4% when excluding Zale. And I would also reference you to see our news release for further details by same store concept. Longer term as Mike mentioned, our three year synergy ending January 2018 has been increased to the range of $150 million to $175 million. Finally, I encourage you to see our non-GAAP reconciliation table on slide 21. We are prepared to non-GAAP reconciliation to provide you with a clear view of the components of our business pre and post acquisition and we hope that you find this information helpful and useful. And with that I’ll turn the call back over to Mike.

Mike Barnes

Thanks Michele that was great. In conclusion, I’d like to once thank to Signet team members worldwide for their incredible contributions to the successful quarter. And now we’ll be happy to take some time to answer your questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) Our first question is from Simeon Siegel with Nomura Securities. Please go ahead.

Simeon Siegel - Nomura Securities

Mike, so as you continue the successful cross-selling, can you talk about the guardrails you have to ensure the specific concepts maintain their own branded entities, I guess. And then, Michele, if we can take you up on your offer. Can you talk about the organic results and the guidance, maybe how was the U.S. organic gross margin rate this past quarter, any thoughts there going forward, and you had really impressive leverage in the organic SG&A rate this quarter, can you talk about that at all, maybe the right way to think about it and then just lastly you mentioned interest, so if you can share the interest expectations for 3Q, that will be great? Thanks.

Mike Barnes

Sure. Thanks Simeon. I’ll start off with the first one, and then maybe flip it over to Mark to give a little bit more color to it. We’re working very diligently to preserve the identities of both Kay and Zale, knowing that they’re both in the malls. Now, one thing that a lot of people don’t realize is the cross over is less than I would have expected certainly if I had taken a guess years ago. I think it’s about 55%, Mark, somewhere in that neighborhood. So we have the opportunity to leverage that aspect of the business, but having said that, we do want to have very strong brand identities for both brands, and we are going to work with, we have not announced yet who and how, but we’re going to work with a major third party consultant firm to help us with some brand studies, marketing studies, and identity of studies going forward. Mark, do you want to add anything to that.

Mark Light

The survey of the research we’ll be engaging, as Mike said, not only he’s talked to consumers and understand what’s going on with the brands, but we’re also going to look at some other companies that have the separate brands with separate divisions, so we’re going to be very thoughtful and methodical on what we do with this, it is a big question not only to our customers but to our people, but this fall we will be testing, it is one data point for us, we’ll be testing 50 Kay stores that will be carrying Vera Wang, and we’ll have 50 Zale stores that will be carrying Neil Lane and be carrying Le Vian, and we’ll also have Open Hearts by Jane Seymour up in Canada in our People stores, and then also be testing Le Vian and Neil Lane up in Canada. So it will be a good data point for us to understand the effects within each store and within the effects store by store.

Mike Barnes

So just to add on to that before we move on to your second question, bottom line is we’re going to do the same thing we always do. We’re going to test before we invest in markets put together these incredible tests that I think are going to give us a lot of information. We’re also going to work with the third party organization to help us with this process, and I’ll tell you that I have never been more excited about this acquisition than I am today. The integration progress is going along very well. I am not wearing rose-colored glasses here just to you guys know. I know we’re going to run into some headwinds along the way and there is going to be issues to deal with. But you know what, we have got the most collaborative experienced management team that I could ever hope for working on this. So I am very excited about the future, and Michele you want to go into the other points?

Michele Santana

Sure, so let me take you through the guidance in a little bit more detail that we provided for the third quarter relating to organic EPS. So, we talked about the adjusted EPS being in the range of $0.12 to $0.18, and when you back out what we provided in terms of the Zale guidance, the $0.21 to $0.19 that kind of leads you to an organic EPS plus financing cost in the range of about $0.33 to $0.37.

Now, what I would say is, you should think about interest costs very similar to the impact that it had this quarter, and that's kind of roughly about $0.10 impact. So, assume $0.10 on the financing which would really get you to an organic EPS in the range of about $0.42 to $0.43, up to $0.46. So hopefully that’s helpful from in terms of thinking of the organic EPS guidance.

I think one of your other questions related to gross margins in the U.S., so giving you a little bit more color on that. The gross margin in Sterling Jewelers division did increased as a percentage of sales by 10 basis points, and that benefit was favorably impacted by both sales mix as well as lower commodity cost. You get a little bit of an offset in there as we’re still kind of winding down the gold hedge losses that we have incurred in fiscal 2014, but I would say substantially that’s behind us just a little bit more to go. And I believe your other question related to SG&A leverage and how to think about that as we move forward. Again, when we think kind of full year, we expect to continue to see leverage on our SG&A rate driven by sales growth.

Operator

The next question is from Lorraine Hutchinson with Bank of America-Merrill Lynch. Please go ahead.

Lorraine Hutchinson - Bank of America-Merrill Lynch

Thank you. Good morning. Just wanted to hear your early thoughts as you begin the integration of Zale, are there a lot of SG&A investments that need to be made this year to get their stores and sales force up to Signet standards, and is that all factored into your guidance?

Mike Barnes

The answer is yes and yes. We are making a lot of SG&A investment. We are holding a leadership conference for Zale for the first time in well over 10 years and we think it’s going to be powerful quite frankly. I mean we have done this annually for the Sterling division for many, many, many years. It’s always been kind of the culmination of starting off our holiday selling season. It really gets the associates and store managers very excited about what we’re going to drive for the holiday selling seasons. They haven’t had that at Zale. And they’re looking forward to it by the way. We’ve had regional management meetings Mark Light, myself and George Murray the President of Zale. We have sat down with the regional managers, we sat with the district managers and we talked about the opportunities going forward and quite frankly I’ve never seen more excitement. When we got the Q&A we’ve a lot of questions from people and that were great questions and people are engaged and that’s really the key here.

They are engaged in the business, they are engaged and then willing to move forward, we’ve made the management transitions that needed to be made, the people that wanted to opt out did and that’s great them, wish them the best, all the best because that were very helpful in this transition quite frankly and I have a lot of respect for both Theo and his management team but you know what, we’ve a new management team going forward. The people are excited and we’re going to make investments in things like leadership conferences that’s what it’s all about.

One of the things that we’ve always sold out there, is that one of our strategic strengths was people and the way that we develop people for the future, the way that we lead them to drive the store sales and it really take us to the future and that’s we’ve always said, the people are most important thing in our company and we believe that and this sales team is incredible, let me tell you there is some unbelievable people down there.

Unfortunately, we’ve been spent a lot of time down there in August was damn hot and I wish it wasn’t but what we’ve found is that the people have just got this great energy and this great excitement about moving forward and taking this thing into the future and so it’s really is a great thing but we’ll invest in that and it have all been built into our forecast numbers and believe me it is a great investment in the future of this company and we believe that we’re going to start seeing some wonderful results starting with the holiday selling season fourth quarter.

Lorraine Hutchinson - Bank of America-Merrill Lynch

Great and as you, what was biggest surprised that caused you to change the synergy target so quickly?

Mike Barnes

Well, I think it’s really a matter of the fact that, when we looked at synergies initially it’s before the close and we’ve to put those numbers out there and as always we took a fairly conservative prudent approach to what we put out there. And we had always hoped that we would find more synergy numbers but I tell you, as we dig into this and Mark, I’ll let him jump in here next because he is an experienced operator in the jewelry industry the most experienced quite frankly and he sees things every day, they are going to be productive to our future in terms of how we can leverage things between all of our divisions not just Zale and Sterling but also the UK division, which he’s been working very closely for the past year.

So, Mark, you want to jump in there with some thoughts.

Mark Light

Yes, to Mike’s point before the announcement we didn’t have visibility really into the business. So the more and more we get involved in, the reality is Zale and Sterling do the same thing, they sell jewelry to middle market sector and that company has been start for investments in their business and they are operating the company more I would say as a turnaround company as opposed to how we operate, for instance, on how to grow and capture additional market share. So, there is a lot of areas of the business that I’ll be specific on that, we just see best practices that we can enable and work with the Zale management team and the Zale people and to Mike’s point they’re very excited, they understand they looked across the hallway and allows the Kay doors and saw investments in technology, saw investments in additional brands, saw investments in advertising, saw investments in merchandising assortments and they are now they’re excited about the opportunities going forward, they have Signet’s invest in those parts of the business that they haven’t had for years. So yes, with the more and more we get involved the more bullish we’re about the opportunities for the Zale division.

Mike Barnes

Yes, and it’s still early days. We hope to find a whole lot more ability to leverage our success across all of our divisions going forward but we think it’s a prudent number taken up by 50% to 75% to 150 million to 175 million at this time and we’re confident and being able to deliver those synergy. Hopefully there is more as we go forward but we’ll wait and see.

Operator

The next question is from Ike Boruchow with Sterne Agee. Please go ahead.

Ike Boruchow - Sterne Agee

Hey everyone, good morning. Thanks for taking my question and congrats everyone on a great integration so far. I guess first question to Michele, for the fiscal year the 538 to 554 just want to make sure I think about it right, does that include a $1 adjusted number for Q2? And then also for Q3 and Q4 just for modeling to help us out, can you help us with what the interest rate and tax rate should like for those two quarters? And last Mike, just the Zale progression throughout the quarter and I know it sounds like the business was negative in the first couple of weeks, can you just talk about what you saw as the quarter kind of progress and you get your arms around the business?

Michele Santana

Yes, so let me start just in terms of the annual guidance we provided with the 538 to 554 that would include our Q2 adjusted results as well and also as I pointed out it includes our finance expense in there. So, for the second quarter I kind of indicated roughly finance equated to about a $0.10 impact EPS. We would expect a similar impact in Q3 and Q4 each of those quarters, now that is fairly normalize interest expense that we can expect to incur. And in terms of tax rate our annual effective tax rate of 29.3% is really what you should end up seeing within each of those quarters. Q2 is a little bit of a strange with our lower rate because again given that we have that lower annual effective tax rate in a higher rate in Q1, it squeezes that quarterly rate down lower but you should expect the 29.3% effective tax rate for Q3 and Q4.

Mike Barnes

The only other thing I would to that Ike is, the team has done a great job in structuring our capital bases and how we did the financing of this deal and how it affects the results for our business going forward. There’s probably going to be some future benefits, not huge may be but additional future benefits because we have not had the benefit of this structure for year. So you might think about that as well.

Ike Boruchow - Sterne Agee

And Mike the progression of Zale is throughout the quarter is kind of what you saw?

Mike Barnes

I’m sorry?

Ike Boruchow - Sterne Agee

Just the progression of Zale, because I mean Zale started up negative diverse coupled with Q4?

Mike Barnes

Yes. Well, let’s talk about that a little bit. That’s a great question. Zale announced that they didn’t have the best Mother’s Day results, which is the strongest part of the quarter. We only own them for the past two months of the quarter and the few months of the quarter and not during that period. Obviously there’s been a lot of transition, integration work going on, lot of operational work, we’re working on inventories. And so I would say there’s been some distraction in the Zale business. They still were accretive to us in the quarter slightly accretive. Obviously, what I’m really excite about is the opportunity in fact, from where they are today to where they can be. And they’ve got the team to do it. They’ve got some great people out there. And with the leadership that I think that we can help to provide them although they already have some great leadership out there in the field. I tell you this district manager and resell manager team, it was a joy to meet with them and work with them. And I think that when we put our collective knowledge together that it just going to be explosive and that overtime, it’s going to take some time, but we’re going to drive that business. We have really been focused on the fourth quarter and we have totaled everyone in both Sterling the U.K. and Zale, don’t let anything to distract you from delivering that important holiday selling season in the fourth quarter. The second quarter, we’re finalizing this deal, we’re getting it done. The third quarter we’re going to be doing a lot of integration work, we’re going to be changing things around. We’re going to be imparting a lot of knowledge from one division to another et cetera. But the fourth quarter, don’t let anything stop you from going out there and executing it at the point of sale. Don’t let operational things get into way, it’s all about helping our customers do two things and that’s to celebrate life and express love that’s our mission statement, everything else you know is only meant to provide those two end results quite frankly. And that’s what we’re doing. And what that does it has a flowing effect and if cash stays down, it increases earnings for our company. It increases our ability to deliver results for our shareholders and to return to capital to our shareholders, et cetera. So all of this things working together, I think are going to be a powerful combination and this is going to be an absolutely incredible transformational acquisition for this industry.

Operator

The next question is from Oliver Chen with Citigroup. Please go ahead.

Oliver Chen - Citigroup

Regarding Zale Corp and your comments on this inventory opportunity there, what’s the nature of the more productive inventory that you can add? And as we look to Zale Corp going forward, we’re comp drivers amongst opportunistic in terms of pricing versus units. Also just the second question on a holiday, if you could highlight what you’re most excited about on a year-over-year basis with respect to marketing? And your thoughts on the pricing and merchandise margin opportunity as we go through holiday; it’s not an easy environment out there with the promotional kind of noise that’s possible.

Mike Barnes

Thanks, Oliver. I appreciate your questions. I’ll kind of start off and then kick it over to Mark and then Michele will kind of have you on a team basis here, a tag-team approach. But to begin with, we have found a lot of unproductive inventory. And our thoughts were -- what, let’s get it out of there, let’s get rid of the unproductive inventory and let’s invested inventory to take this company forward. And we have the ability to do this, so let just make it happen. There is no secret in the fact that our terms have been substantially higher than Zale terms in the past. And we intend to close that gap it’s going to take some time. I think Mark mentioned in his prepared remarks that we’re really working on up in their inventory returns over time and give us a little bit of time to do that but this is a great start for us to pull out a lot of unproductive inventory and to really build back into some very productive inventory. Mark you can talk about some of the drivers that you expect for the fourth quarter.

Mark Light

Yes. First, we look at the unproductive inventory, but these determine was unproductive and more importantly as we’re going to invest in money and we look at the fast turning classifications of best selling brands, the faster turning programs and quite frankly and even there is a little bit spark we won’t getting the appropriate refurbishments of maximize sales. So the first place is the most productive programs and products that they have and that’s all going to reinvest, where we’re excited on the futures if you look at the Zale’s store and their brand portfolio in comparison with Kay store brand portfolio, you notice that Kay has a lot more brand. So we believe there is a opportunities to continue to expand Zale’s brand portfolio to a thoughtful methodical strategic testing before we invest methodology we believe there is a great potential to get involve with more brands have opportunity to start future with Zale. We’re also excited just about some of the basis where we started investing in Zale systems and sharing our inventory size best practice with Zale we just think there is going to be a lot of opportunities just in refurnishing the assortment of the generic inventory.

Mark Light

Also notwithstanding the comp results of Zale during the second quarter or we saw a incredible result as Mark was just mentioning in some of their branded opportunities. Vera Wang continues to be a strong brand for them. The celebration diamond collection continues to have a lot of strength. I think to Mark’s point unstoppable love which is the moving diamond that we talked about that is so powerful right now, they just had invested enough into it and didn’t have the proper inventory to drive the business during the important parts of the selling seasons and that’s what we’re working on with them. We believe that overtime we’re going to create synergy that with collaboration of all the divisions that we can have expertise in inventory management and how to drive sales through the execution of how we buy and sale our inventory over the future and that’s going to make the big difference in how you see turns in this industry going forward at least within our company. And Michele, do you want to take the financial question?

Michele Santana

What was the financial element Oliver I’m sorry, do you have financial question there as well?

Oliver Chen – Citigroup

Yes, I was curious about as you do engage in the journey as well, what comp drivers you think will be the biggest factors in terms of units or transactions or maybe a combination of both?

Mike Barnes

I will jump on that, Oliver, because I think that is a great question. One of the things that we have seen at Zale, I think it is important to call this out and we really haven't talked about it today much, is the fact that while comps in the second quarter were not particularly great, what was great was margin. We continue to see increased -- strong increase in margin and I think one of the things that Mark and his team are really going to have to tackle is a strong look at the balance between driving sales and driving margin. This has been one of the big things that we have worked on in the UK over the past year and quite frankly with some ideas behind especially our diamond business, which is not as strong in the UK and which is becoming much more stronger now with the collaboration with the US team, Mark and his team working with the UK, I think the same thing at Zale. We really need to figure out the appropriate balance between driving sales and driving margins with the overall goal of driving profitable store growth long term. That is what it is all about. It is all about profitable growth, long-term consistent results. That is really all that matters to us, not about the short term. They have done great in driving margin up, especially as cost inputs have come down over the last couple of years, but we need to drive the sales as well. And I think with the team working together that we will start to see a balance similar to what we are seeing at Sterling and that is a balance of comps being driven by a combination almost equal of transaction and cost depending on where cost inputs go in the future. But right now, what I see is a healthy balance. There have been many years where it has been driven by cost alone at the expense of transactions and there were years a long time ago where it was driven by transaction and not cost. But right now, I think there is a pretty healthy balance and I think we are in a good position to help get that team onto the right page in terms of balancing driving their sales and maintaining their margins. The bottom line is that they have done well from an operating income standpoint, but we believe that there is a lot more opportunity out there.

Oliver Chen – Citigroup

Thank you. And Michele that’s really helpful, what are your thoughts in the holiday season with pricing and merchandise margin Mike I know how last year given from volatility in the traffic you guys strategically levered some allowances set to offer better deals. So how are you thinking about that with respect to the upcoming season?

Mike Barnes

Are you talking about in terms of promotions?

Oliver Chen

Yes.

Mike Barnes

Right now I think that and Mark can speak to this as well as Michele I feel like from a promotional standpoint we’re probably going to be somewhat in line with prior years. We don’t really see the need at this point to drive additional promotional activity out there. Our expectation is not that this season is going to be highly promotional or highly discounted. We’ll see what the competition does. But we think that we can maintain our status in terms of driving sales and margins on a fairly balanced basis without having to go overboard anyway promotionally.

Michele Santana

Yes, and I would just echo that, Oliver, that the goal would be broadly maintain margins. Again, I would just point out that when we are all in, including the Zale operation, Signet's overall margins will be dilutive just given that they currently are operating at a different cost structure, but hence the opportunity on a going-forward basis.

Operator

Dorothy, your line is open. Dorothy Lakner, Topeka Capital Markets.

Dorothy Lakner - Topeka Capital Markets

In terms of the 150 million to 175 million in synergies I wondered if you could break that down a little bit in terms of where that’s coming from piece by piece. Secondly, I know Mark spoke to eliminating the non-productive inventory at Zale prior to the holiday. I just wanted to make if you could clarify that. I just want to understand how that process is going to work. And then on the Jared Vault just how the new merchandise initiatives are going to rolled or the timing in terms of the rollout of merchandising initiatives there? Thanks.

Michele Santana

So Dorothy let me take the first part of your question dealing with the breakdown of the synergy target of 150 million to 175 million. Previously, we had disclosed our initial target of 100 million we had provided about 50 million of that would come from margin sourcing opportunities about 20 million from SG&A savings and then about another the residual 30 million coming from cross selling and repair service opportunities. So what I would say is I think looking at the 150 million to 175 million range I would tell you to broadly think about that in the same terms as what we had previously provided for the breakdown of that.

And again I think some elements of it might come a little bit bigger than others we’re still kind of looking at that three year full fiscal period. And then I think your second question was dealing with non-productivity inventory so maybe Mark you want to jump in on that.

Mark Light

Reference to non-productive inventory, we started pulling out inventory in July a large bulk of the inventories with the three months process we start in July we’ll go through August and September a large proponent to the inventories being pulled out this month which kind of is another issue that relates to the Zale’s numbers so their stores will work on pulling inventory out and they’ll be pretty much finished in September pulling out the inventory and we will start replenishing the faster more productive inventory that will start coming into the stores September, October and into beginning of November. So we’ll see the lot of benefits of that inventory obviously in the fourth quarter.

As far as Jared Vault goes the new merchandise products which was going to differentiate the Jared Vault stores from all the other outlet competitors will have a little bit more of the Jared players so we’ll have Pandora in some of our Jared Vault stores we’ll have a different type of offering there is so much like is in some of our Jared stores but it with the product that is different from that the Kay or Zale’s and competitor sets so all of the new inventory for the Jared Vault stores will be in the stores by the beginning of the fourth quarter by November 1st.

Mike Barnes

One of the things that we probably haven’t driven home as well as maybe we should have is number one I tell you that this outlet opportunity has been a terrific opportunity for us as we converted the Ultra Stores into Kay’s and now the remaining ones into Jared Vault’s we’re seeing incredible opportunities to really grow the productivity of that business and it’s exciting. And now one thing that we shouldn’t overlook in the Zale acquisition is that they were right up there with us in terms of outlet business and number of stores. So we have a much more powerful portfolio to move forward with and we’re going to be able to drive a much more powerful business. We have learned a tremendous amounts as we have put a big focus on outlets following the Ultra acquisition and its worked. So we’re excited about where we go from that entire business is going and by the way we’re testing it in the UK. Mark has worked with Seb. They have put together a test of 5 to 6 stores?

Mark Light

5 to 6 stores just well led Ernest Jones/collections that will be testing in half of dozen stores in this fall in the UK also.

Dorothy Lakner - Topeka Capital Markets

Great.

Mike Barnes

So we’re keeping the foot on the pedal in this thing and it’s totally working for us at this point and we’re just excited about the growth in the business.

Dorothy Lakner - Topeka Capital Markets

That’s perfect and just one more housekeeping question; I just wanted to understand mixture on the interest expense we should be modeling for the third and the fourth quarter?

Michele Santana

Yes, so Dorothy, on interest expense component, we’ll follow broadly similar to what we saw in the Q2 and if you pick up the interest expense of the P&L and kind of ran it down that was about a $0.10 impact. So what I would say, looking at Q3, Q4 it’s a $0.09, $0.10 impact of how you should be thinking about.

Mike Barnes

Alright, thanks Dorothy and at this point we have time for probably one more question before we run so, please go ahead operator.

Operator

Last question is from Jeff Stein with Northcoast Research, please go ahead.

Jeff Stein - Northcoast Research

Okay, I would like to have question A and question B real quickly. First of all, Mark, I just want to make sure I understand what do you do with the inventory that you’re pulling out of Zale store and how does that run through the P&L and is that one of the comp drivers that you see? And then second part is, high level given fact that you’ve taken the synergy guidance up from 150 to 175 and looking at all the puts and takes, do you see the accretion for next year still being high single-digit in the first 12 months? Thank you.

Mark Light

Okay, I will deal with the first part of the inventory and then turn it over to Michele on how we deal with the accounting of it. There are several options, Jeff, in what we do with the inventory. One is that we work with our vendor community and we talk about working with them on some deals on how we can send back product and repurchase other product. There are other options. We have over almost 300 outlet doors that we have a lot of outlet doors, which is the perfect place to liquidate and get rid of this type of inventory. So those are the two main areas, the two main vehicles that we are looking at.

Michele Santana

Yes, and Jeff from a P&L standpoint, so with the opening balance sheet how we go through and determine the fair value step up of inventory is also considering any component of non-productive inventory. So that kind of get swept up in part of that process. So, when we look at what happens from the P&L standpoint, effectively what we’ve done is, we’ve written that inventory down to the value that we would expect to receive and a recovery on. So as that clears out and we liquidate that inventory or return it back to the vendors that we’ll get and added in the P&L at the same time or receiving the recovery. So dollar wise it should not really have an impact to the gross margin dollars now it will end up impacting the rate because it is really a zero amount that’s going to be running through there so I would expect some slight impact.

And then I think your second question relating to with the increase in synergies and how do we think of next year with Zale operations and as accretion I think at this point we’re still committed to what we’ve said before was it being high single-digit accretive and I would say at this time that view has not changed and potentially maybe there is opportunity for us to revisit half of that where we sit today.

Operator

That was the final question; I’d now turn the call back to Mr. Barnes.

Mike Barnes

Thank you and thank you all for taking part in this call we really appreciate your interest and your support. Our next earnings call will occur in November when we’re going to review our third quarter results. I hope you all have a great day, great holiday weekend and thanks again and good bye.

Operator

Thank you. Ladies and gentlemen this concludes today’s conference. Thank you for participating. You may now disconnect.

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Source: Signet Jewelers' (SIG) CEO Mike Barnes on Q2 2015 Results - Earnings Call Transcript
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