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Executives

Theo Killion - Chief Executive Officer, President and Director

Matthew Appel - Chief Administrative Officer, Chief Financial Officer and Executive Vice President

Roxane Barry - Director of Investor Relations

Analysts

Rick Patel - BofA Merrill Lynch

David Wu - Global Crown

William Armstrong - CL King & Associates, Inc

Zale (ZLC) Q3 2011 Earnings Call May 25, 2011 9:00 AM ET

Operator

Good morning. My name is Christie, and I will be your conference operator today. I would like to welcome everyone to the Zale Corporation's Third Quarter Fiscal 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 on the Zale Corporation Fiscal Third Quarter 2011 Results Conference Call . I'm Roxane Barry, Director of Investor Relations. On the call today are Theo Killion, Chief Executive Officer; and Matt Appel, Chief Administrative Officer 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 quarterly report on Form 10-Q for the fiscal quarter ended January 31, 2011.

Also please note that during this conference call, we will discuss certain non-GAAP financial measures as we review the company's performance. One of these non-GAAP measures is adjusted EBITDA, which is defined as earnings before interest, taxes, depreciation and amortization adjusted to exclude charges related to store closures. We use this measurement as part of our evaluation of the performance of the company. In addition, we believe this measure provides useful information to investors. Please refer to the Investor Relations section of our website for a copy of our Form 8-K dated May 25, 2011, which contains the reconciliation of this non-GAAP measure to the most comparable GAAP financial measure. Now I'll turn the call over to Matt.

Matthew Appel

Thank you, Roxane, and good morning, everyone. The third fiscal quarter of 2011 was one in which we continued to make significant progress towards our goal of stabilizing the business and returning Zale to profitability. There were several key positive developments that Theo and I will be covering on today's call. First among these relates to the SEC investigation of the company. In April, we were informed that the commission had completed the investigation of Zale Corporation that began in September 2009 with a recommendation of no enforcement action against the company. This determination by the SEC has allowed us to redirect our resources and more sharply focus on the management of the business.

Moving now to our third quarter results. We are pleased to report the second consecutive quarter of solid progress in the recovery of the business. Revenues for the quarter ended April 30, 2011, were $412 million, an increase of $52 million or 14.5% compared to $360 million for the same period in the prior year. The increase in revenues, is primarily due to significantly higher same-store sales, an increase in revenues recognized on our lifetime warranty product and appreciation of the Canadian dollar, net of revenues attributable to 55 stores closed during the past year. Comparable store sales for the third quarter increased 15.2% compared to a decrease of 2.2% in the prior year. The increase in comparable store sales was driven by a 14% increase in the number of customer transactions accompanied by a 2% increase in average transaction price. At constant exchange rates, which exclude the effect of translating Canadian currency denominated sales into US dollars, comparable store sales increased a very healthy 14.2% for the quarter.

During the third quarter, the Canadian dollar strengthened approximately 6% relative to the US dollar with an average exchange rate of approximately $1.03 compared to approximately $0.97 in the prior year quarter. Impact on the 2011 quarter's earnings was not significant as the rate differential almost equally impacted all P&L line items.

Gross margin for the quarter ended April 30, 2011, was 50.1% compared to 50 .8% for the prior year period. The decline of 70 basis points was due primarily to the impact of higher commodity costs and a change in mix of merchandise sold in the quarter as compared to last year, partially offset by higher warranty revenues and lower inventory evaluation reserves as a result of better inventory turn. Commodity prices continue to be an area of focus as pressure on diamond, gold and silver costs continued during the third quarter. On average, diamond prices are up approximately 20%, gold prices are up approximately 25% and silver prices are up approximately 100% from a year ago. As we replenished our core inventory during the quarter, it became necessary to accept additional selective price increases. At the same time, we began multiple price tests in select markets in April. Preliminary results on these tests are promising, and we will be implementing price increases across North America during the fourth quarter. Our objective remains to maintain gross margins above 50% while continuing to regain market share. We believe this is a realistic and achievable goal.

SG&A expense for the quarter was 49.1% of revenues as compared to 53.9% of revenues in the fiscal 2010 period, or $212 million compared to $194 million in the same period in the prior year. As our sales increase, we are naturally beginning to realize SG&A leverage even as we make selective incremental investments. The increase in SG&A expense of $8 million during the quarter was due to the following factors: increased marketing in the quarter of approximately $6 million, all of which was attributable to television advertising, newspaper inserts, catalogs and internet banner ads for Valentine's Day; and higher payroll and performance-based compensation earned by our field organization as a result of higher sales, partially offset by lower severance and professional fees than in the prior quarter. Other, consisting primarily of activity related to closed store reserves was approximately $2.1 million better year-over-year, resulting in a credit of $0.3 million.

For the third quarter of 2011, we posted an operating loss of $5.4 million compared to a loss of $24.7 million in the prior year period, representing an improvement of $19.3 million. As a result, operating margin for the quarter was negative 1.3% compared to negative 6.9% in the comparable fiscal 2010 period. Demonstrating the magnitude of the improvement in our business, trailing 12-month EBITDA adjusted for charges related to store closures now stands at positive $14 million compared to negative $90 million one year ago. An improvement of $104 million. Interest expense for the third quarter of 2011, was $8.7 million compared to $2 million in the prior year. This quarter's interest expense reflects $5.1 million for the senior secured term loan, which closed during the fourth quarter of fiscal 2010 and an increase of approximately 220 basis points year-over-year and the interest rate on our revolving credit agreement.

In the third quarter of fiscal 2011, we recorded an income tax benefit of $4 million compared to a benefit of $12 million in the comparable period last year. The income tax benefits for both 2011 and the 2010 quarters were primarily attributable to additional net operating loss carrybacks identified and recognized during their respective quarter pursuant to the Business Assistance Act of 2009. At this juncture, we believe that any additional carrybacks will not be material. Loss from continuing operations for the quarter ended April 30, 2011 was $10 million or $0.31 per share. In the prior year quarter, loss from continuing operations was $15 million or $0.46 per share.

We ended the third quarter with 1,173 fine jewelry stores and 673 kiosks for a total of 1,846 retail locations, compared to 1,224 fine jewelry stores and 677 kiosks for a total of 1,901 locations in the prior year quarter. During the quarter, we closed 24 fine jewelry stores. We also opened one kiosk and closed 2 kiosks for a net decrease of one in the quarter. Our expectation continues to be that we will selectively open stores where the opportunity is compelling and close stores that are underperforming if the economics makes sense. At this time, we have plans to close approximately 10 fine jewelry stores and 7 kiosks in the fourth quarter of this fiscal year. In fiscal 2012, we currently plan to close approximately 20 fine jewelry stores and 5 kiosks.

Now let's turn to the balance sheet. Inventory at April 30, 2011 stood at $756 million compared to $693 million at the end of the third quarter last year. The increase of $63 million after the impact of stores closed during the past year, was due to the following factors: approximately 1/3 of the increase reflects the impact of higher commodity prices on our inventory, 1/3 is due to merchandise purchased to fuel the level of sales activity we are experiencing, and the final third is due to the combined impact of a higher Canadian exchange rate and lower inventory valuation reserves as a result of better inventory turn compared to last year.

Another positive development during the quarter relates to our asset-backed credit facility. During April, we announced that maturity of $120 million of the credit facility had been extended approximately 3 years to April 30, 2014. These commitments were previously scheduled to mature on August 11, 2011. In aggregate, commitments under the credit facility remain unchanged at $650 million, including a $108 million seasonal adjustment. We are particularly pleased in the interest expressed by new financial institutions during the financing process. This extension to our bank facility exemplifies the growing confidence of the financial markets in the progress we have made in our turnaround program.

As of April 30, 2011 the Company had total outstanding debt of $375 million compared to $299 million as of April 30, 2010. In addition to the term loan of $140 million, long-term debt included $235 million borrowed under the revolving credit facility. Total available borrowing capacity as of April 30, 2011 stood at approximately $194 million compared to $123 million as of April 30, 2010, an increase of approximately $71 million. During the third quarter of 2011, capital expenditures totaled $3 million compared to $2 million in the 2010 quarter and were devoted primarily to technology infrastructure investments. Our expectation is that capital expenditures will total approximately $16 million for fiscal 2011.

I would now like to comment on sales results from the Mother's Day selling period. From May 1 through May 8, representing our Mother's Day selling period, we had a positive sales comp of approximately 10%. Theo will elaborate on Mother's Day in just a moment.

In conclusion, while we are pleased with the improving financial profile of the business, we remain steadfastly focused on achieving our #1 goal of returning the business to profitability. All of our efforts, day in and day out, are designed to improve our competitive position and deliver value to our shareholders. I would now like to turn the call over to Theo.

Theo Killion

Thank you, Matt, and good morning. Let me begin by giving more texture to the third quarter results. First and importantly, our dedication and commitment to rebuilding our core merchandise assortment continues. As we make progress in each category, we've been rewarded at point-of-sale by our guests. You will recall that in February 2010 when Gil Hollander and the merchant team began analyzing the business, our total merchandise assortment was 60% core, with some categories requiring more work than others. Over the course of the last year, as we increased core product in bridal, solitaires, earrings, pendants, anniversary bands and men's, we began to see strong positive comps in those lines. We focused first on the wedding categories so that we could reclaim our market position as the diamond store. During the third quarter of this year, diamond fashion, color, metals and watches have also begun to show positive comps.

We are uncompromising in our focus to rebuild our merchandise assortments, but we also know that we have to be flexible as the market conditions dictate. As Matt indicated earlier, we are methodically testing in order to respond to commodity price pressures. Throughout the spring season, we've been making selective price increases while running price tests in all of our brands. When we raise prices for selective merchandise in the fourth quarter, we will also hold prices constant in other area. Importantly, we've added opening price points in each merchandise category in order to continue to make our brands accessible to all guests. Finally, we have not and we will not be compromising product quality. We are committed to offering beautiful jewelry at affordable prices with consistent quality that our guests can trust.

Our promotional focus for the quarter was Valentine's Day. Our television ads in the United States and Canada were supported by strong campaigns online in our catalogs with direct mail, newspaper and in-store promotions. And while we spent $6 million more this quarter than the same quarter last year, Rich Lennox and the marketing team continue to be focused on efficient campaigns that are integrated across entry points for all of our brands, speaking to our guests with a single voice.

Strategic partnership is a theme that emerged during the quarter and will continue to be an important element of our business strategy in the future. Matt mentioned the addition of new participants in our asset-backed loan group. During the quarter, we also announced an important partnership with LoyaltyOne, a division of Allied (sic) [Alliance] Data Systems. LoyaltyOne runs AIR MILES INCENTIVES, the premier loyalty reward program in Canada. 70% of all Canadians are members of the program, and their purchasing behaviors are significantly influenced by incentives offered by retailers who are members of the program. As the exclusive Canadian fine jeweler in the air miles program, we've added a proven, cost-efficient promotional tool that will differentiate us from our competition while also driving incremental traffic to our stores.

In the past, I've talked about our commitment to investing in our people. One example of this is the robust on-boarding programs we've implemented for regional directors, district managers and store managers. Everyone who interfaced with the guests has to complete diamond basics, a course designed to teach the fundamentals of diamond selling. A second example is the extension of the Diamond Council of America certification program. By the end of the fourth quarter, we expect that approximately 45% of our full-time jewelry consultants will be DCA certified, up from 35% at the beginning of this quarter and 15% at the end of fiscal 2010.

During the quarter, we made 3 important announcements about talent that reinforced our commitment to the growth, development and the investment we're making in expanding capabilities through people. Jeannie Barsam was named Senior Vice President, Merchandise Planning and Allocation this quarter. With over 20 years of retail leadership in MP&A as well as merchandising, Jeannie has proven at brands like Charlotte Russe, Talbots, The Gap and The Limited that she knows how to improve inventory efficiency, drive sales and grow profitability.

Toyin Ogun also joined this quarter as Senior Vice President, Human Resources and Customer Service. Toyin brings over 25 years of human resources experience in his assignment. He has in depth knowledge in the areas of recruitment, performance management and organizational development. He has been instrumental in building organizational bandwidth at brands like L.L. Bean, Sears and The Limited. Welcome Jeannie and Toyin.

Before I offer my comments on Mother's Day, I'd like to congratulate my partner, Matt Appel, for his promotion to Chief Administrative Officer. He's promotion is an acknowledgment from the Board of Directors for a job that has been and continues to be well done. Matt's strong financial acumen, his process orientation and the leadership that he provides for his team and the organization have been vital to the progress we've made in the last 18 months. Congratulations, Matt, well deserved.

Now for some commentary about Mother's Day. As with Valentine's Day, we increased our spend on television, newspaper and direct mail to deliver a more efficient and consistent marketing message to our guests across all media. We are being creative in how we connect with our guests through traditional and nontraditional means. The best example of this integrated approach was our What Mom Wants program. We used our Facebook page to ask mothers across the country what they wanted for Mother's Day. We had 22,000 votes cast with the choices for the perfect gift. We then created a consistent marketing message online and in store where we identified the SKU and categories that moms wanted with special signing. Importantly, these categories experienced an over 50% lift during the Mother's Day selling period. That campaign was part of our overall Mother's Day marketing strategy that helped to contribute to our positive results.

During the quarter, I spoke to a number of our top-performing store managers and district managers, and I also had the opportunity to travel to Gulf Coast and Toronto markets with Becky Mick, our Chief Stores Officer. The field organization of our Zales brands and our Pagoda brand are critical to helping us execute our turnaround plan. The passion, drive and ownership on the part of the teams that serve our guests give me great confidence that our field organization is on the right path.

Before I close, on behalf of the entire sales team as well as myself, I want to offer heartfelt condolences to Denise Goldberg, Zach Goldberg and Max Goldberg. Neal's untimely passing impacted all of us. He was more than a colleague. He was a friend, and our thoughts are with his family.

As always, thank you to our investors, our vendors and our over 13,000 team members. The progress that we've made and continue to make can't be done without you. I'd now like to turn the call over for questions?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Rick Patel of Banc of America Merrill Lynch.

Rick Patel - BofA Merrill Lynch

Can you provide a little bit more color in terms of your price increases? Specifically, which concepts did you test price increases for in April? And as we think about the fourth quarter, how much should we expect your -- you to raise average ticket buy in order to keep your gross margin goal of 50%?

Matthew Appel

Sure. We've been testing price increases across all products, Rick, and our price tests have been going quite well. We haven't yet made the determination of precisely where we're going to make the price increases, but we do know that in about one month's time, we will roll out those price increases. So we'll comment more about that when we talk about our fourth quarter results, but for now, expect there to be significant price increases in line with market trends occurring in about one month.

Rick Patel - BofA Merrill Lynch

And can you help us understand the composition of your sales mix in terms of diamond jewelry, gold and silver? And as we think about this inflationary pressure, how much should we expect your merchandise costs to increase as a blended rate over the next few quarters?

Matthew Appel

I'm not going to predict the merchandise cost increases over the next few quarters. I direct you, instead, to the impact that it's had on the margin for this quarter. It was about 160 basis points due to increasing costs. But we're -- we remain firm in our goal, and I think we have a -- not "I think." We have a strategy to maintain 50% margins going forward, post price increases. And so we understand the commodity cost increases, and we have a plan and a program to deal with them and to maintain our objective.

Rick Patel - BofA Merrill Lynch

Great. And just lastly, can you help us understand how we should be thinking about modeling SG&A going forward? You talked about having some store closures, which I'm assuming will give you some rent relief and staffing cost relief, but you also have increased marketing. So how should we think about those 2 balancing each other?

Matthew Appel

Sure. Well, our SG&A for the -- as well as all of our other financial targets for fiscal '12 have not yet been confirmed or established, so I'm not going to comment on the next fiscal year. But I think just generally as it relates to SG&A, the way to think about it is that we're going to make selective, strategic investments in marketing and in personnel that have ROI to fuel the recovery and the growth of our business. But they'll be done while enhancing the leverage that we get from the SG&A as you experienced this quarter.

Theo Killion

I think in terms of individual personnel moves that we'll be making the future, we have a pretty rigorous test to make sure that those things impact ROI. Last year, we added a couple of district managers to decrease span of responsibility, which paid off very nicely for us. We're looking at doing that again selectively, probably in Canada, not in the United States. But having the district managers in the stores on a regular basis really pays off for us, so we'll be making some of those selective investments.

Operator

Your next question comes the line of Bill Armstrong of CL King and Associates.

William Armstrong - CL King & Associates, Inc

I was wondering if you could break out for us the comps by Kiosk versus Fine Jewelry and maybe U.S. versus Canada.

Matthew Appel

Bill, we don't report comps per se for Kiosk versus Fine Jewelry, but what I can give you is the year-over-year sales growth in each of those segments. So for Fine Jewelry, that was 15.7% year-over-year, and in the Kiosk segment, 8.2%.

William Armstrong - CL King & Associates, Inc

Okay. You closed 24 stores during the quarter. Could you just give us a sense for which concepts that might have broken out to, outlets versus Zale or Gordon?

Matthew Appel

It's clearly not in the outlet part of our business. It tends to be more Zales and Gordon's, but we're really not -- we're discriminating, if you will, on the basis of financial return and on the basis of rent versus sales opportunity.

William Armstrong - CL King & Associates, Inc

Got it. On the gross margin line, down 70 bps year-over-year, you talked about commodity costs. I think you also mentioned mix, the sales mix during the quarter. I was wondering if you could maybe flesh that out a little bit for us.

Matthew Appel

They're not unlike the prior quarter, a slight shift in mix to lower margin, high-volume diamond product, which is our core. And so nothing in any way alarming about the trend of our business, but simply higher commodity costs and that shift in the mix have combined to bring the margin down some. But I think one thing that's really noteworthy is how much our warranty line is contributing to the business. We've had strong growth in warranty sales, and warranty was worth almost 100 basis points of improvement in the quarter. And so the warranty products, both the lifetime product as well as our one-year product in Pagoda, have resonated quite well. They have contributed strongly to this year's results.

William Armstrong - CL King & Associates, Inc

Okay. So the warranty side of your 14.2% comps, warranty revenues were about 100 basis points?

Matthew Appel

Yes, that's right.

Operator

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

David Wu - Global Crown

First, can you first just talk about maybe how the comp progressed through the quarter? Clearly, you've previously indicated the comp in the beginning of the quarter was up around 11 -- around 12%, I believe, and it suggests that March and April to accelerate, but it would be helpful if you could perhaps provide some more color on that?

Theo Killion

David, we're not going to breakdown month-by-month at this point. Obviously, we had an acceleration as the quarter continued. Retail, in general, had pretty strong April, and we were certainly in line with that.

David Wu - Global Crown

Great. And just secondly, did you see any changes at all to the promotional environment during the quarter?

Theo Killion

Internally, what we've done year-over-year is actually eliminate about 220 promotional events, and we're starting to get to a much more methodical, thoughtful approach to our own promotions and our own marketing and not reacting to things as they present themselves in mall or in competition. In terms of the competitive landscape, obviously, in the jewelry sector, Mother's Day was an important focus, Valentine's Day in the quarter, but nothing that was unusual over the quarter, David.

David Wu - Global Crown

Excellent. And just lastly, can you provide any color on how credit sales are trending?

Matthew Appel

Sure, David. In the third quarter, the U.S. proprietary credit sales were up about $6 million year-over-year. Approval rates were up 2% year-over-year, and the average credit sale was also up 5%. So very -- performed very strongly in the U.S.. In Canada, the stats are essentially flat across all of those measures for the quarter. But in Canada, recall that proprietary credit is significantly lower portion of our tender mix as it tends to be 20-ish percent. So not as significant.

Operator

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

Theo Killion

Yes, I want to thank everyone for participating in today's call and thank everyone for your support. With 7 consecutive months of positive comps, we now have a solid foundation for execution of the next stage of our turnaround plan. Thank you.

Operator

Ladies and gentlemen, that concludes the Zale Corporation Third Quarter Fiscal 2011 Results Conference Call. We appreciate your time. You may now disconnect.

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