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Zale Corporation (ZLC)

F2Q07 Earnings Call

February 21, 2007 9:00 am ET

Executives

Betsy Burton – CEO

Rodney Carter - CFO

Cindy Gordon - Controller

David Sternblitz - Treasurer

Analysts

Janet Kloppenburg - JJK Research

Adrianne Shapira - Goldman Sachs

Jeff Stein - KeyBanc Capital Markets

Marc Bettinger - Stanford Group

Julie Chapgier - Merrill Lynch

Lauren Levitan - Cowen and Co.

Bill Armstrong - CL King & Associates

Melissa Otto - W.R. Hambrecht

Justin Boisseau - Gates Capital Management

Brian Tunick - JP Morgan

David Mann - Johnson Rice

Presentation

Operator

I would like to welcome everyone to the Zale Corporation Second Quarter Earnings Conference Call. (Operator Instructions) I would like to turn the call over to Ms. Betsy Burton, President and Chief Executive Officer. Ma’am, you may begin your conference.

Betsy Burton

Thank you, Sheila. Good morning and thank you for joining us for our second quarter conference call. I am Betsy Burton, Chief Executive Officer of Zale Corporation. With me on the call today are Rodney Carter, Chief Financial Officer; Cindy Gordon, Controller; and David Sternblitz, Treasurer. Before we begin, Rodney will review the Safe Harbor.

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Rodney Carter

Our commentary and responses to your questions on this conference call will contain certain 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.

Information concerning some of the factors that could cause actual results to differ materially from those contained in the forward-looking statements is available in our annual report on Form 10-K for the year ended July 31 2006 and our quarterly report on Form 10-Q for the quarter ended October 31 2006 as filed with the SEC.

In addition, we may present financial information on this call that would be considered non-GAAP financial information. For a reconciliation of each non-GAAP financial measure to the most directly comparable GAAP financial measure, please refer to the company’s most recent sales and earnings release which can be found on our website, www.zalecorp.com under Financial Information and then News Releases.

Betsy Burton

Thank you, Rodney. Q2 results were in line with revised expectations. Comp store sales increased 1.4%, down from previously reported November-December comps, but a direct result of our focus on maximizing gross profit dollars in the January post-holiday period. Earnings were above previously revised guidance or earnings per share of $1.94 when you exclude the impact of derivative accounting and the change to a lifetime jewelry protection plan.

Here are some of the highlights for the quarter. We gained nice sales momentum for the Zales brand. This was the first positive comp for the Zales brand in three years and the first increase in operating earnings in four years. While we gave back margins due to aggressive pricing and increased promotional activity at holiday, we changed our focus in January to maximizing gross profit dollars.

Progress was also directly related to planned investments and inventories as customers reacted favorably to an expanded product assortment in our core diamond fashion and bridal categories, partially offset by decreases in semi-precious and precious.

We also maintained a 98% in-stock position through holiday, so we were able to meet the demands of the business at the most critical time; and a return to the diamond store, new TV creative and better media placement proved successful in driving traffic into the stores.

Perhaps even more important was our significant investment in people at sales during the second quarter. The largest investment was in hourly payroll with the focus on attracting and retaining our lead sales associates. We also tested increases in hours of coverage to improve overall customer service and satisfaction. While these investments produced better results than in the control group, the real return will be measured in years, not months.

During the quarter, we also replaced our two-year jewelry protection plan with a lifetime jewelry protection plan at Zales and in Canada. As a result of the change in product offering, the company changed to the straight-line method of revenue recognition for new sales. The impact of the change was a reduction in recognized revenue of $15 million, while at the same time generating $24 million in deferred revenue that will be recognized in the future. So we collected a lot more cash and believe the change was the right business decision; unfortunately the accounting doesn’t reflect it.

On to the Gordon’s brand. Comp sales declined and we believe the Zales brand took some share from the Gordon’s brand. Recently, there was a leadership change at the Gordon’s brand with the appointment of Steve Lang as Senior VP of Gordon’s, directly responsible for merchandising, marketing and operations, reporting directly to me. This change in leadership has a twofold objective: bring best practices from Zales to Gordon’s, and stop cannibalization between brands.

Steve played a key role in many of the successful merchandising and marketing changes at the Zales brand. His work there being substantially complete, we believe his strength and product knowledge can now be leveraged at the Gordon’s brand. All of our database analysis suggests the customer profile is virtually the same for both Zales and Gordon’s. We believe we can eliminate redundancies and increase efficiencies through standardization of core SKUs. Better coordination of pricing and promotions should also benefit both brands going forward. Common product assortments and shared SKUs are also part of the strategy to transition to a centralized merchandising organization over the next 12 to 18 months.

Now onto the other brands. Bailey’s had a slightly positive comp for the quarter. This continues to be fueled by growth in designer product and luxury watches and an increase in average ticket. This quarter, the brand opened its first freestanding location in November and also successfully launched its new value-priced palladium line in solitaires.

Pagoda had slightly negative comps as it continues to anniversaries the success of Italian charms as well as some consumer price resistance to the higher cost of gold. The number of transactions was down significantly, largely offset by an increase in average ticket.

Outlet had a solid comp increase this quarter with strong performance in its core bridal and diamond fashion categories and large diamond solitaire rings. New stores are also exceeding pro forma projections as we continue to see good results from our expansion into power centers.

Canada again had an outstanding double-digit comp performance with increases across most categories. Diamond fashion and diamond solitaire jewelry led the growth, also contributing to a strong increase in average ticket. Gross margin rate was also up 60 basis points as a result of the direct importing of diamond fashion as well as the elimination of the Canadian excise tax.

Last, investments in our e-commerce business continued to payoff. Holiday traffic was up 23% over last year. Conversion was up 50%, and total revenues were up almost 75%. Also, during the quarter Zales.com successfully launched Build a Ring, customization option for engagement rings, three-stone rings and wedding bands. Bailey’s website was also redesigned this quarter and sales have tripled. Next up will be the launch of Gordons.com this spring.

So bottom line we’ve had some clear successes and we have also learned from our mistakes. Excluding the overall hedge losses for fiscal 2007 the change to a lifetime jewelry protection plans and some non-comparable gains in fiscal 2006, operating earnings year over year would essentially be flat. While some brands had growth in earnings this was offset by investment spending and others.

Our focus in the second half is on maximizing gross profit dollars and expense reduction, particularly those investments in payroll and marketing that did not generate sufficient sales gains to justify. We also remained committed to testing, especially as we refine our pricing and promotional strategy at the Zales and Gordon’s brands.

For Q3 we now expect a comp store decrease of 2% to 3% and diluted EPS in the range of flat to up $0.04 and for Q4 we expect comps to be flat to slightly positive and diluted EPS in the range of minus $0.05 to minus $0.01, excluding the impact of derivative accounting and the change to a lifetime jewelry protection plan.

For full year fiscal 2007 we are projecting total revenue growth of 3% and flat comp store growth when you adjust for the Bailey Banks & Biddle store closures. Excluding the change in jewelry protection plan, we are projecting a 40 basis point improvement in gross profit or 52.2% this year compared to 51.8% last year; and diluted EPS in the range of $1.46 to $1.52 excluding the impact of derivative accounting and the change to a lifetime jewelry protection plan.

I’d now like to ask Rodney to review the financials and then we will open up the call to questions.

Rodney Carter

Thanks Betsy. The following are the key statistics for the second quarter of fiscal 2007. Comp store sales increased 1.4% for the quarter. As Betsy noted, most of our brands had positive results with Gordon’s and Piercing Pagoda down low to mid-single digits. Total revenues increased 4.2% for the quarter and 3.9% for the year to-date, excluding the impact of the revenue recognition for the jewelry protection plan in the quarter and revenues from the Bailey Banks & Biddle stores closed in the second quarter of fiscal 2006.

As Betsy discussed, revenue was impacted by a change in accounting method resulting from a change in our jewelry protection plan offering to our customers. Our historical product offering provided for two years of service and revenue, was recognized based on historical relationship with the percentage of the costs incurred over the service period. Given that the product offered in the second quarter extended the service period to cover the lifetime of the product and the nature of the accounting literature, we thought it necessitated the most conservative method for revenue reorganization at this time. Adopting straight line revenue recognition criteria for the lifetime product resulted in a negative impact to previously issued guidance of $0.19.

While the increased selling price resulted in incremental sales of approximately $9 million, the impact of the change in methodology resulted in increased deferred revenue of $24 million. However the adjustment has no impact on cash flow.

The average transaction for the quarter by brand was as follows: Zales $354 this year compared to $338 last year; Gordon’s $381 compared to $394 last year; Bailey’s $1,602, up from $1,559 last year; Outlet $395, up from $380 last year; Peoples $296, compared to $286 last year; Pagoda at $43 compared to $41 last year. The Zales average transaction increased as the mix shifted back to diamond fashion from lower-priced gold and silver product.

Gross margin declined by 40 basis points, including the impact of gold contracts under hedge accounting, but excluding the impact of the lifetime jewelry protection plan, and the $6.2 million of charges in last year related to the disposition of Bailey Banks & Biddle inventory. The aggressive pricing strategy and breadth of Brilliant Buys in the diamond categories contributed to a decline in gross margin for the quarter of 51.2% of sales versus 51.6% last year. Direct sourcing of solitaire product and direct import of finished goods provided the ability to sharpen price points, thus lessening margin erosion.

SG&A, including the costs of insurance operations was 34.2% for the quarter versus 34% last year as a percentage of revenues, after excluding the impact of the change in the lifetime jewelry protection plan offering, store closings and executive severance last year. The increase was primarily a result of increased investment and payroll in the Zales brand and the deleveraging from increased occupancy expenses. Including the impact of the lifetime jewelry protection plan on revenue recognition, SG&A was 34.5% in the second quarter of fiscal 2007.

Operating earnings for the quarter were $146.8 million or 14.6% of revenue. Operating earnings for the quarter, excluding the impact of derivative accounting and lifetime jewelry protection plan revenue recognition in fiscal 2007, executive severance and store closures for fiscal 2006, were $157.7 million or 15.5% of revenues in fiscal 2007 versus $158.1 million or 16.2% of revenues last year.

The effective tax rate for the quarter was 37.7% versus 28.3% last year. Last year, the effective tax rate included an $11.5 million or $0.23 per share income tax benefit, resulting from the repatriation of foreign earnings under the American Jobs Creation Act. Excluding the repatriation impact, the effective tax rate for the quarter was 37.7%.

Net income for the quarter under hedge accounting for the impact of forward purchase contracts of gold and silver, excluding the impact of revenue recognition for the jewelry protection plan, was $95 million or $1.94 per diluted share versus net income of $97 million or $1.96 per diluted share last year. As reported, net income was $88.1 million or $1.80 per share compared to $87.8 million or $1.78 per share last year, including the Bailey Banks & Biddle store closures, executive severance and the tax repatriation benefit.

During the quarter, we opened ten stores and three kiosks. We closed 14 stores and 12 kiosks. We remodeled and refurbished nine stores and 15 kiosks during the quarter. We ended the quarter with 2,353 locations as follows: Zales 790, Gordon’s 285, Bailey 73, Outlet 136, Peoples 187, Peoples II 72, and Pagoda at 810.

The capital expenditure plan is approximately $90 million for the fiscal year with the total target of 55 new jewelry stores primarily in Peoples, Zales and the Zales Outlet brands and nine new Piercing Pagoda kiosks.

Merchandise inventory at January 31st 2007 was $1.1 billion or $161 million or 16.8% higher than last year at $957 million. The increase in inventory is a result of three primary drivers:

First, the Zales brand has approximately $51 million remaining of the clearance and discontinued merchandise it identified at year end. In addition, the brand has $50 million related to investments to drive both holiday and future sales. However, to the planned inventories, the brand has only over approximately $10 million or 2%. While we remain committed to clearing out the discontinued merchandise and planned reductions in the level of ongoing assortments throughout the spring, we believe the investments to be in items that are consistent with the brand positioning and represent items with solid sell-through.

As a final note, $37 million of the increase is attributable to our internal assembly organization. As Betsy noted, we believe there are additional benefits to be obtained from this initiative.

Inventory turnover on the rolling 12 months basis was 1.2 times versus 1.25 times last year. We ended the quarter with $32 million in cash and borrowings of $233 million under the line of credit compared to $37 million in cash and borrowings of $120 million last year. The increase in borrowings is primarily due to increased inventory levels.

Accounts payable and accrued liabilities are approximately $40 million lower than January 31 2006 primarily attributable to lower income taxes payable and the reduction in liabilities due to the settlement of Bailey Banks & Biddle lease obligations and severance in the prior year.

Betsy has provided insight into the ways we are working to enhance sales and margins, as well as comments on some expense-related points. As an organization we are working our way through all aspects of the business, starting with driving top line growth, gross margin enhancement, more efficient expense structure, a disciplined focus on real estate strategy, all focused on enhancing long-term returns on capital and increased shareholder value.

The transition to a more centralized merchandising organization, the ongoing evaluation and evolution of key business processes and expense structures and a disciplined focus regarding existing and future real estate decisions is expected to result in meaningful improvements of the financial performance for Zale Corporation in coming years.

This process is neither simple nor short term. As Betsy has mentioned on several occasions, the transition for the company will take some time and will incorporate ongoing refinements to the strategy as the results of our numerous sales merchandising, operational and business process initiatives evolve. We are focused on driving shareholder value for the long term and believe the company is being positioned to achieve that goal.

As Betsy stated, our estimates for the third quarter reflect a range of comparable store sales from down 2% to 3% and diluted per share of flat to up $0.04. For the fourth quarter we now expect comparable store sales to be flat to slightly positive and diluted earnings per share from a negative $0.05 to negative $0.01.

The company’s guidance excludes the impact of derivative accounting and the change to its jewelry protection plan offering and the related revenue recognition. The impact of the derivative accounting is not quantifiable because it is market dependent and the expected impact from the change to its jewelry protection plan is approximately a cost of $0.15 in the third quarter and a cost of $0.14 in the fourth quarter.

David and I will be available to discuss any questions you may have after the call. We will now open up for questions.

Question-and-Answer Session

Operator

Your first question comes from Janet Kloppenburg - JJK Research.

Janet Kloppenburg - JJK Research

I was wondering if you could talk a little bit about the gross margin strategy. If you hadn’t been so price aggressive in the second quarter, what do you think would have happed to the top line? I guess that’s reflected in your go-forward guidance but I am wondering if the competitors are going to be sharply priced, just, how you plan to react to that? I am a little bit confused about the strategy.

Betsy Burton

Sure. As you know, we are trying a lot of different things. I think the belief was that by being aggressively priced we would be able to drive a lot stronger comp store growth than we were able to. So we have since refined the strategy. There was a lot of learning from that, I think probably the most costly was the aggressive pricing on what we call our Brilliant Buys, and because of that they became a much more significant part of our sales mix. So it wasn’t just the aggressive pricing; it was a shift in the mix to again the more sharply and aggressively priced Brilliant Buys. We have pulled back from that.

We recognized and I think the shift in strategy going into January, unfortunately because of holiday we were really locked into the pricing and promotional strategies that were in place. In January we went back to a strategy of clearly trying to maximize growth profit dollars which means that you give up a little bit of top line but you are able to get back more in terms of growth margin dollars. So our strategy will shift back to a more normalized growth margin strategy going forward.

Janet Kloppenburg - JJK Research

That will enhance your market share?

Betsy Burton

There is a fine balance between growing market share and growing market and growing gross profit dollars. What we are trying to do is optimize the balance between the two but not trying to gain market share at the expenses of profit.

Janet Kloppenburg - JJK Research

As the direct sourcing becomes a bigger component of your overall product assortment, do you think then you will become more aggressive on pricing?

Betsy Burton

No, I think part of what we also learned this holiday was we did use the benefit from direct sourcing to help fund some of our more aggressive pricing, and I do not believe that will continue going forward. The strategy going forward is to look to direct sourcing as an opportunity to improve gross margin.

Janet Kloppenburg - JJK Research

Can you comment on your Valentine’s Day performance?

Betsy Burton

Sure. We were slightly disappointed and there is a lot of noise; and as you know, unfortunately the last two days of Valentine’s we were hit with snow storms and severe weather. So I think it was probably pretty hard to read. I think we attribute about $0.04 or $0.05 of EPS loss to the last two days of closed stores, but we did learn some things and overall I guess it was about slightly below our expectation.

Janet Kloppenburg - JJK Research

Is that incorporating the weather effect or not?

Betsy Burton

We have decided we are not carving out weather as any kind of an excuse. We are looking at this as it was a combination of trend and a combination of other external factors. But our guidance incorporates our results from our Valentine’s selling period.

Operator

Your next question comes from the line of Adrianne Shapira - Goldman Sachs.

Adrianne Shapira - Goldman Sachs

Hi. Betsy, just given the shift in promotionality and now, as you say, maximizing gross profit dollars, can you give us a sense of what traffic trends have been like? I mean on the heels of Christmas as you kind of pull back promotions, give us a sense of what has happened to traffic already heading into the Valentine’s Day season as you pull back some of these Brilliant Buys?

Betsy Burton

Well, actually mall traffic in general, it’s not just the Zales brand, I think all of the brands have experienced a decline in mall traffic. So, again, it’s not specific to the Zales brand, but we have actually gone back to an interesting strategy which seems to be working, and that is a different promotional cadence as it relates to our everyday pricing. So we are trying to refine, we are testing a lot of different things.

There is one combination of pricing and promotion that seems to have the most promise, but, again, we are trying to drive sales also by increasing average ticket, not just transactions.

Adrianne Shapira - Goldman Sachs

Can you give us a sense, given your testing a lot of different changes to your promotionality, give us a sense of what this will do to your marketing calendar and your events?

Betsy Burton

We have two things to consider. We have to look at what we are up against last year in terms of promotional events, but we are going into the first week of March. We have actually upgraded our register capabilities because we were handicapped in December because we were unable to test different kinds of regional pricing. So going into March, we will be testing three or four different combinations of everyday pricing and promotional event, and we will then, whatever we learn from that in terms of what is the most profitable way to maximize gross margin dollars, we will then incorporate that in our Mother’s Day event plan.

Adrianne Shapira - Goldman Sachs

Okay. So from the customers’ perspective, relative to last year, Mother’s Day will be less promotional than last year?

Betsy Burton

Not less promotional, just hopefully more effective

Adrianne Shapira - Goldman Sachs

Just shifting gears a little bit and talking about, you had mentioned, it sounds like payroll, you perhaps over invested in some areas and perhaps you didn’t see the return on some investment. Can you provide some color exactly what worked, what didn’t work? Just following on that, it sounds as if you had been highlighting the field organization as an opportunity to perhaps narrow the gap competitively. How do you plan to do this going forward?

Betsy Burton

Sure. I’ll start with some of the things that didn’t work. We increased hours of coverage. So, for instance, instead of opening with two people, we might have opened with three or four in some stores that had very low hours, we felt that by giving them additional payroll that perhaps they could capture additional market share. It worked in some instances and then some instances it didn’t. So we are going back and obviously paring back hours where they were not justified.

I think in terms of investing in our associates. There were two things that we did: One, we wanted to make sure we did not lose an elite, and so we adjusted some of their hourly rates to make sure we were competitive. In terms of adding an elite, we added almost 200 new elites to our stores and the additive payroll in those stores, if you look at the stores where we added a elite, we clearly saw additional lift versus stores where we did not increase payroll.

So I think you could say overall in balance, that strategy was successful. I think we have learned a lot from how and where to invest payroll dollars, but again very strictly going back and making sure that they pay for themselves year round, not just at holiday and we are in the process of really completing those analyses as we speak.

In terms of the field itself, we believe we have a great opportunity in terms of really training. We turned a lot of the regionals in terms of our overall strategy, which is to make sure we attract industry leading regional mangers. And so we now have some fairly new regional managers that the emphasis now will be in training and making sure they take their learnings to the store level, to the store manager. So we are focusing primarily our efforts at the regional manager training level and also at the store manager training levels.

Adrianne Shapira - Goldman Sachs

So net-net, is there still an incremental investment there given the fact that you’ve perhaps invested in some areas that you will pull back, and net-net, is it still increasing the training investment there?

Betsy Burton

Yes, net-net, we have increased payroll. We will be paring back where it wasn’t productive, but we have no intent of paring back in terms of where we made investments for the long term, which means obviously the elites will continue over the entire year. And the continued investments in training and store manger training will result in a net-net increase in payroll.

Operator

Your next question comes from the line of Jeff Stein - KeyBanc Capital Markets.

Jeff Stein - KeyBanc Capital Markets

Good morning. Betsy, I would like to talk a little bit about the extended service agreement. In the first quarter conference call, I think you did make a comment to the effect that it wasn’t a material impact on profitability, and it looks to me it is going to be fairly material. What has changed? Is it the amortization period? Exactly what is causing it?

Secondly, why are you not incorporating this into your guidance because it is a pretty material number?

Rodney Carter

Jeff, this is Rodney. We had based the conversations in Q1 based on the initial conversations and consultations that we’d had with our accounting firm and the research that we had collectively done on existing literature. As we continued that process on, as there was not a bright line, we determined at this point to take that into account in the most conservative way and convert from a historically statistically proven amortization basis, a revenue reorganization basis to a straight line, which obviously slows down. So that’s exactly what’s happening. We are booking a lot more cash.

We think that this is a very attractive and very profitable product, but the timing of the revenue reorganization is such that it slows that down. I did give comments on the guidance in roughly $0.15 in Q3 and $0.14 in Q2 for the impact of that.

Jeff Stein - KeyBanc Capital Markets

Well, I am just kind of curious, Rodney, why this is not being incorporated into guidance because that’s the way you are going to be reporting it on a go forward basis?

Rodney Carter

I think this is a recent transition and that your question is valid; it will be phased in and normalized.

Jeff Stein - KeyBanc Capital Markets

Can you talk about the impact, the $0.19 impact, that you booked through the first half of the year? Is this just based on service agreements that were sold this year or are you going back retroactively incorporating all service agreements that have been sold today? In other words, are you converting prior two year agreements into lifetime agreements or is this just agreements that you’ve sold this year?

Rodney Carter

This was exclusively product sold in the second quarter that were sold as lifetime jewelry protection plans. There is no impact and we are certainly very comfortable with the amortization of the other products. We simply did not have an explicit history beyond the prior period, and so I think we are extremely comfortable with the statistically proven method that was used on those others, and it was purely forward of the change in product design.

Jeff Stein - KeyBanc Capital Markets

Okay. Why are you not converting Gordon’s and the other division to this method?

Betsy Burton

We actually did in January. And again, this is one of those anomalies where you sort of scratch your head and go “My God, this is a great business decision”, where we increase our incremental sales in terms of average that we collected on the lifetime versus the two year, and obviously we collected a lot of cash. But because of the conservative nature of accounting and the fact that it’s a new product, we are having to account for it this way. But the cash is there, it’s on the balance sheet and it’s clearly a success from a business decision standpoint. Yes, we have rolled it out to the other division.

Jeff Stein - KeyBanc Capital Markets

Okay. And one more question on this, I don’t want to dwell on it too much but it is a little bit confusing. What kind of amortization period are you now using? And based on your best guess, when is the crossover point so that it is no longer a drag on profits?

Rodney Carter

Rather than comment on the specific period, it’s well beyond several times what the period of the prior product was. So it will take a number of years, probably three years to cross over where it’s net neutral from a GAAP P&L standpoint.

Jeff Stein - KeyBanc Capital Markets

But what you are saying from a cash flow standpoint it is accretive and can you tell us roughly how accretive you expect it to be?

Rodney Carter

The entirety of the lift, we sold just on a higher price point for the product, we sold about $8 million to $9 million more in revenue.

Betsy Burton

That’s just the Zales brand in one quarter.

Rodney Carter

Just the Zales brand in one quarter, so obviously we are accruing a very large amount of deferred revenue which will start reversing back out over period of time.

Jeff Stein - KeyBanc Capital Markets

A final question separate from this, Betsy, I am wondering if you could just talk a little bit about the centralized merchandising strategy that you are planning to roll out at Gordon’s? I’d take it that what you are doing is combining the Zales and Gordon’s merchandising organization. How much do you expect to save it out of this, is it baked into your guidance? Are you at all concerned about being able to differentiate the brands or losing the ability to differentiate the brands if you have a common buying organization?

Betsy Burton

Sure. Let’s talk about the strategy for now. We believe that the right way to approach it is to make it evolutionary, not revolutionary. So the first start was to start homogenizing the assortment of the Gordon’s assortment with the Zales assortment. We are starting with the ZAP SKUs and by Mother’s Day a 100% of the ZAP SKUs will be the same, and as you can imagine that creates big efficiencies in terms of our buying and production operations. By holiday, we anticipate at least 60% to 70% of the SKUs to be in common. We do not believe it will be a 100% the same assortment.

I do agree with you that we do need to have certain exclusives that can help differentiate one brand from the other. In addition to that, the Gordon’s by the nature of the location and the concentration of their stores and the markets that are slightly more ethnic the assortments may also need to be more tailored. So we believe probable 30% of the assortment at Gordon’s will be unique to Gordon’s.

Jeff Stein - KeyBanc Capital Markets

How many of the stores operate in the same malls?

Betsy Burton

254 stores are in the same malls, about 40 Gordon’s I guess. The second part of your question, in terms of the savings, we have not factored anything into our guidance. We believe that the actual change in terms of moving to a centralized merchandising group will most likely happen next February, post holiday. So even though the common assortments will be in place for this holiday we will again not evolve into a central merchandising organization until fiscal ‘08 and well into the second half of fiscal ‘08. So at this point we have not incorporated any overhead savings with obviously there will because of the elimination of the redundancies we have not incorporated that in our guidance, and we really have not even issued guidance for fiscal ‘08

Jeff Stein - KeyBanc Capital Markets

Betsy, today approximately what percent of the SKUs for holiday of 2006 were the same for Gordon’s and Zales?

Betsy Burton

I would say if we looked at ZAP, only 5% of the ZAP SKUs were in common.

Jeff Stein - KeyBanc Capital Markets

You say ZAP SKUs, what does that mean?

Betsy Burton

I am sorry, our direct diamond procurement in assembly operation what we call our direct sourcing of diamonds; in other words, loose diamonds in assembly that’s what we refer to it as ZAP, but that is what we refer to as direct sourcing and of that diamond solitaires and studs which are primarily the focus of our direct sourcing operation currently, there were only about 5% of the SKUs that were identical in terms of color, clarity, carat weight, et cetera. So, and then in terms of total, I am guessing the probably 5% to 10% at most were the same in the holiday ‘06.

Operator

Next question comes from the line of Marc Bettinger - Stanford Group.

Marc Bettinger - Stanford Group

A couple of quick questions. The Street for the third quarter was at the mid 20s and you’re looking flat to plus four. If I understand you correctly, you are looking to increase the gross margin and consequently the same-store sales through the fall, correct?

Betsy Burton

Correct.

Marc Bettinger - Stanford Group

Where does that $0.20 odd differential come in?

Betsy Burton

Okay. First of all in a light quarter, you basically deleverage expenses on the smaller sales base. So I would say that’s the bulk of it. On top of that clearly as I mentioned we are making investments in our store associates and some of those investments don’t have a immediate payback in a light quarter. However we still believe that they are good investment. And so again the decreased sales is the primary lever in terms of deleveraging your expense base with relatively fixed rent.

Marc Bettinger - Stanford Group

The increased gross margin, how does that account for the leftover clearance from 2006 that I assume you are trying to move out to the remainder of Q3 and Q4?

Betsy Burton

The clearance really won’t impact margin. As you recall we actually still have about $22 million worth of the reserve that we booked in Q4. So when we are more aggressive with clearance it’s pretty much offset by the reserve that we got booked. So we do not anticipate clearance to be a material factor to our gross margin.

Marc Bettinger - Stanford Group

Okay. So from accounting standpoint book to bill, but we should see the clearance in the stores?

Betsy Burton

Correct. It has always been in stores. We didn’t really take the clearance out. We just backed off of our aggressive promotions. So we will be testing a lot to see whether as to move out as much clearance as possible without impacting our regular price sales or our average ticket.

Marc Bettinger - Stanford Group

Big picture, looking at how Canada. I think you mentioned that Canada did very well with your comps and so on, higher gross margins. Can you compare and contrast a little the environment of why Canada did very well and Zales lagged behind?

Betsy Burton

In Canada I think we enjoy a unique position in terms of market share leadership clearly with a 20% market share and you have a lot of advantages. It’s a less competitive market. I think the other significant difference is the culture there is a lot different. People are much longer-term employees. They’ve got pride in their jobs and also the benefit in terms of gross margin, they are much further along the curve of direct sourcing and now really they are focused on increased importing of finished goods. So, their total direct sourcing is way ahead of what Zales brand is here.

If you remember, if you looked back when we originally talked about Canada, it really was about four, five years ago when the turnaround there began. So they are now in about their fifth year and have really worked out and hopefully what we will be doing, but not in five years, hopefully we can shorten that time period because of the learnings that we’ve taken from Canada and the leadership that is now in place at Zales North America. We believe that we can dramatically shorten that turnaround time. But again there are differences in the two markets especially in terms of the competitive landscape.

Marc Bettinger - Stanford Group

Well given that difference in the structure of the unique position, less competitive and so on, what gives you the confidence that you will be able to translate to the Zales brand if it doesn’t have those same characteristics?

Betsy Burton

Well, we believe that in terms of translation, if you look at the merchandise assortment the strategy and in terms of promotional strategy, returning to the diamond store, all of these we believe were great successes. So we already believe that the strategy which we brought back, which it was interesting because when Zales Canada originally started their turnaround they basically took some of the things that Zales was doing right and took it to Canada. So basically we are bringing back a lot of the things that worked before and are obviously working now. So we feel very good that the merchandise assortment, the planogram strategy, the going back to the diamond stores, the TV creative and the TV strategy, we fell very good about all of that. So we believe that you can already draw the conclusion that there are far more similarities than there are differences between the two markets.

Marc Bettinger - Stanford Group

Okay, terrific Betsy. Good luck.

Operator

Your question comes from the line of Julie Chapgier - Merrill Lynch.

Julie Chapgier - Merrill Lynch

Hi. I was wondering if you could give us a little detail on how your sourcing initiatives are progressing. What percent of the Zale flagship brand is sourcing diamond right now?

Betsy Burton

We have got two kinds of direct sourcing, so I’ll start with ZAP, which is our diamond procurement and assembly, and if you were to look at the Zales brand in particular, there has been a huge increase. If you look at year-to-date fiscal ‘07, our ZAP purchases represent 14.4% of our total receipts, and they were only 3% last year. So 14% versus 3%. That just compares to Peoples, which was at 18.5%, which is up even from last year’s 17%. So in total across all brands, ZAP was 11% of receipts and about 6% last year, so double, almost double. If you were then to overlay the finished goods imports, clearly, we have made significant progress there as well.

On the Zale flagship, we have gone from 22% last year to about 25%. So, in total, across all brands, our direct imports are 22% this year versus 18% last year. So if you were to put that all together and say total direct sourcing this year is year-to-date 33% versus last year 25%.

Julie Chapgier - Merrill Lynch

Great, that’s very helpful. And how does that help you in terms of margin expansion?

Betsy Burton

Well, it didn’t really in the Zales brand for this holiday, but going forward, clearly, that is the objective. I think the test that was being run was to see if in fact we could improve quality, give it to the customer at the same price and increase market share and secondarily be aggressively priced on our Brilliant Buys. We learned, we made a few mistakes and so going forward, the goal and objective clearly is to increase our gross margins through direct sourcing.

Julie Chapgier - Merrill Lynch

Do you have any stated goals for sourcing and an overall timeline?

Betsy Burton

Well, it’s hard to say. We believe we could get that 33% up to 50% overtime.

Operator

Your next question comes from the line of Lauren Levitan - Cowen and Co.

Lauren Levitan - Cowen and Co.

Betsy, I was hoping you could spend a little bit more time on the Gordon’s and Zales strategy. Is there any liquidation of any Gordon’s products required in advance of this common merchandising organization that you are trying to build for Gordon’s, or is that accomplished without having to undertake any clearance on the Gordon side?

Betsy Burton

Sure. We do not believe there will be a massive clearance. I think I would call it ordinary course. Every spring, all of the brands go back and do what we call style outs and look at their what worked, what didn’t work. The beauty of this strategy is you’ve got the Gordon’s with the Zales product, and so basically it is taking best of both worlds. In fact, some of the Gordon’s best selling SKUs will now also be in the Zales brand. So it works both ways.

But in terms overall inventory, the Gordon’s brand is looking to bring in about $15 million of inventory, but of that only about 2.5 will be asset. In other words, a lot of the vendors, because they see the potential, will give us the product on memo and then obviously once it proves successful, we will then convert that to asset. So we do not see any major shift in terms of increasing Gordon’s inventory and/or increase in amount of clearance. We simply will phase out. In other words, when you run out of the product, you then turn on the switch to order the common SKU as opposed to the SKU that was currently in the bin. That’s why we call it an evolution. We are not looking at this as overnight; we are trying to align the two product assortments and taking massive markdowns to move out the old. We are looking at this as a transition where we identify and tag the SKUs that will replace existing SKUs.

Lauren Levitan - Cowen and Co.

Given this change and just your overall view of how you are approaching the Gordon’s business, I know in the past the company has talked about it as a possible square footage growth driver. Do you still think that’s the case? Is there sufficient differentiation between the Zales customer and positioning and, if you are not sure of it yet, what timeframe do you think you would need to assess this new merchandise strategy before you could determine whether or not there is growth potential in Gordon’s square footage?

Betsy Burton

Actually, clearly, we have proved in Canada that the Mappins and Peoples can coexist very well and they have common assortments except for what I call these exclusive items which differentiate each other. So we feel very comfortable. If you look at our major competitor, obviously, they have sister brands in the same mall in common assortment. So we believe that the strategy is a sound strategy.

In terms of the Gordon’s model, we believe we have gross margin opportunity at Gordon’s first and foremost, and that will obviously help improve their four wall productivity. And we have identified 50 locations where there are currently Zales stores doing greater than $2 million where we do not have a Gordon’s store, and we have empirical evidence that would suggest they both would do quite well in those same malls. So we will be looking at very strategic growth with the Gordon’s brand and other time do believe that it could become a second national brand.

Lauren Levitan - Cowen and Co.

Okay, that’s very helpful. One other topic I wanted to hopefully have either you or Rodney address is gross margin. Can you clarify in Q2 the overall gross margin? I got myself a little confused with the things we were pulling out versus last year. Can you clarify what you see as the relevant gross margin shift from LY in Q2 and again give us, directionally by brand, what the drivers were?

Related to that, as you think about the long-term impact of both direct sourcing and some of these investments you are making in store payroll and training and other areas, do you have a new operating margin target that you would be willing to provide us? Thank you.

Rodney Carter

Well let me answer the last question first. We are working in kind of a scrub down all through the P&L, all through the balance sheet as I had alluded to. So there is not necessarily a near-term target on operating earnings that I want to communicate, but can certainly communicate some of the pieces.

I think the big drop of this year to last year from a GAAP perspective of gross margin starting out about 51.6, approximately 40 basis points or so was the pricing markdown, the promotionality to this year. The backing out of the impact of the lifetime protection plan, jewelry protection plan, is about 60 basis points with the remainder being basically the hedge accounting impact.

Lauren Levitan - Cowen and Co.

One last question on the lifetime versus two year protection plan, you said there was $8 million to $9 million, I think you said, incremental revenues, but are you seeing any difference in attachment rate?

Rodney Carter

The attachment rates actually even up.

Lauren Levitan - Cowen and Co.

Even at the higher price point?

Rodney Carter

Even at the higher price point.

Betsy Burton

Right.

Lauren Levitan - Cowen and Co.

So they definitely find the lifetime more compelling than two years?

Betsy Burton

From a marketing and business standpoint, it is absolutely a great decision.

Operator

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

Bill Armstrong - CL King & Associates

Hi, good morning I guess a couple of question that are mostly follow ups at this point. So for Valentine’s, I know you guys were hit with the storms on the last two days, but prior to that, just to clarify, were trends still below your expectations even before the storm set?

Betsy Burton

Yes again, mall traffic was down. We were finding that usually the weekend before Valentine’s is a big weekend. So we were disappointed in overall traffic and trend, but again it got clouded by the severe whether. It’s really hard to separate out how much was trend and how much because, so much of your holiday is in the last two days.

Bill Armstrong - CL King & Associates

Right. So you don’t think that you saw maybe people looking at the weather forecast and maybe coming to your stores a day or two earlier than they might have?

Betsy Burton

I wish. But I think Valentine’s, guys always just wait to the last two days and it just was unfortunate timing.

Bill Armstrong - CL King & Associates

Okay. So your sales are a little lower than expectation, gross margin so should be a little better than your original, but overall earnings are well below your original guidance from the beginning of the year for Q3.

Betsy Burton

I think in a light quarter such as Q3, when you make investments in things such as the payroll and then when you focus on gross margin dollars, which means your sales are going to decline, you deleverage our expense structure. So, again, that’s 90% of it is in the deleveraging of your expense structure.

Bill Armstrong - CL King & Associates

With the elite, you said you added almost 200 elites to your stores. Were those new hires or were those promotions of existing employees?

Betsy Burton

Those were new hires. The pay back on your new hires and your elites is really you have to look at a full year. In other words, it’s, we believe, very clearly, that if you can take somebody that was making $10 an hour and replace them with in an elite at a higher hourly rate, and pay them a higher commission. If you take out the other hours, the net should result in greater sales and greater productivity. But again, I think payroll investments, you have look at with a little bit of a longer time horizon. Clearly, the payroll investments that were not productive, we can peel back. But I think we need to be very cautious to jump to any kind of conclusions because it’s very early in terms of looking at their return and their pay, the payback on those decisions.

Bill Armstrong - CL King & Associates

With the protection program, is that lifetime of the product or lifetime of the customer?

Betsy Burton

We have always wondered that same thing. It’s really about the lifetime of the product, but the real question is what happens when someone dies? Do they give it to someone else? But the real key is you have to bring in your receipt and you have to have proof of that lifetime protection plan. So let’s call it the life of the piece of paper.

Bill Armstrong - CL King & Associates

So is it true that diamonds are forever in that case?

Betsy Burton

If you’ve got that piece of paper, they are.

Bill Armstrong - CL King & Associates

So, but seriously, with the amortization period then, what are you using for this lifetime plan?

Betsy Burton

Rodney has signaled me that he is very clear, we do not want to divulge the life of it. But I can assure you as CEO, it is very conservative.

Bill Armstrong - CL King & Associates

I see. Okay. So, and I don’t know if you want to disclose this either, but just maybe to give us a little perspective on how much more a typical lifetime plan would cost versus a two-year plan. If I bought a $5,000 diamond, what would I have paid for a two year protection plan versus a lifetime protection plan?

Betsy Burton

I would say 30% more, in the range of. It depends on the price range. We are at a very granular schedule, but on average 30% more.

Bill Armstrong - CL King & Associates

Even with that, attachment rates are up?

Betsy Burton

Substantially.

Bill Armstrong - CL King & Associates

Why do you think that is?

Betsy Burton

Partially from a marketing standpoint, it’s got a lot more appeal than after two years, you can re-opt. In other words, people like to know, and I think it’s all in training, but I think the brands that introduced it, which was again Zales and Canada, I think they did an excellent job of training the associates. Interestingly enough, we have got customer satisfaction indexes that people can fill online surveys, and we have gotten extremely positive feedback in those brands that if in fact they were offered a lifetime jewelry protection plan, it actually increased their overall satisfaction and customer experience. They look at it is a positive. It’s only if sold after you have actually closed the sale and it’s perceived by the customer as value add. In other words, everybody just dreams of or fears, and especially with ring sizing, people fluctuate late and have to have their ring sized up or down and then if you are buying an expensive piece of jewelry, you want to know that if in fact if a diamond gets chipped, you can get it replaced. So I think it’s very compelling to our customers and it seems again, perceived favorably by the customer.

Bill Armstrong - CL King & Associates

Right. So in Q2, that was just for the Zales and Gordon’s division and now you’ve rolled it out to all the other divisions?

Betsy Burton

Actually, we had tested it in the Gordon’s division in a small way, but it was really only Zales in Canada, so it does not include Gordon’s and Outlet. They were rolled out in mid January.

Bill Armstrong - CL King & Associates

Okay. And how about Bailey Banks & Biddle?

Betsy Burton

No Bailey’s does not offer it.

Operator

Your next question comes from the line of Melissa Otto - W.R. Hambrecht.

Melissa Otto - W.R. Hambrecht

Hi, good morning. I would say almost all my questions are answered, but I just had one quick follow up. Would you just give me a little bit more color on your advertising strategy and what sort of mediums you are going to be using?

Betsy Burton

Sure. In particular with the Zales brand, which is the one that advertises obviously the most heavily, we really believe we have the right advertising strategy, which is a TV campaign, which, again we returned to the diamond store. We’ve had very positive feedback on the commercials themselves. In fact, I hear everybody when they hear the Vanessa Carlton music, A Thousand Miles, come on, they don’t even have to look at the TV; they know it’s a Zale commercial. So we are continuing with the use of that song as well as the overall creative, and we found that the combination of sort of the emotional touch, but also with the call to action is probably the most successful formula. So we really do not see any changes in our advertising strategy at this point in terms of either amount of money or media. I think we were very pleased also with the results of our improved media placement this year versus last year as well.

Melissa Otto - W.R. Hambrecht

Thank you very much.

Betsy Burton

Thank you.

Operator

Your next question comes from the line of Justin Boisseau - Gates Capital Management.

Justin Boisseau - Gates Capital Management

I was wondering, you mentioned that the accounting change had no not effect on your cash flow. What was the cash flow from operations for the quarter and what do you expect it to be for the year?

Rodney Carter

For the year, it’s essentially going to be slightly negative due to the investment in inventory, and it was essentially flattish; I’m talking about from operations itself. Essentially flat for the quarter.

Justin Boisseau - Gates Capital Management

What was the CapEx for the quarter then?

Rodney Carter

$50 million.

Justin Boisseau - Gates Capital Management

Are you still looking for around 64 D&A for the year?

Rodney Carter

Yes.

Operator

Your next question comes from the line of Brian Tunick - JP Morgan

Brian Tunick - JP Morgan

I was just curious how you would characterize your second half earnings guidance, because looking at the past five years, right, you have earned anywhere from $0.20 to $0.35 in the second half so breakeven for this year is a significant decline. So maybe you can just give us a little more color on kind of the thought process behind your guidance. Do you think it’s conservative, realistic, some thoughts on that?

Rodney Carter

I would say it’s very balanced. I think clearly the back half reflects, as Betsy talked about, the biggest difference is the investments in the infrastructure, some of the modest sales expectations as we rebuild traction, the impact from deleveraging, particularly of SG&A-related investments of new stores, of occupancy costs and of payroll. So I think we would expect to return back to more normalized trends, but the near-term guidance, particularly for Q3, reflects that deleverage.

Brian Tunick - JP Morgan

Okay. And then interest expense, do you still expect about $10 million to $11 million for the second half similar to the first half?

Rodney Carter

A little bit less than that. Closer to $8 million.

Operator

Your next question comes from the line of David Mann - Johnson Rice.

David Mann - Johnson Rice

Rodney, in terms of the expense reductions that you commented on, can you give a little more detail beyond perhaps the payroll rollback and any kind of marketing rollback in terms of areas that you would look to take costs out of the business?

Rodney Carter

Let me give that in kind of a macro comment, and what I was trying to achieve in some of my prepared remarks, David, was kind of an overall look at process. With modest sales over time, SG&A has grown as a percent of total. We want to look at the revision of some of those processes whether it’s the centralized merchandising that Betsy talked about that not only has some process improvement opportunities, it also has interest expense, savings, commonality and stream line of inventory investments.

We want to be very prudent and disciplined on marginal real estate investments which while they are certainly not an impairment risk that’s addressing on an ongoing basis, there are opportunities to return on capital if we make very prudent decisions either on renewals extensions, new stores remodels and really try to elevate the returns overall.

So in the comment that I made is this is neither short term nor simple; we want to make decisions that drive value long term as opposed to have too quick of a reaction to cut areas that would help drive long-term profitable growth in sales and earnings.

Betsy Burton

Just to add to that, we have found that when you look for pennies you actually can find lots of money. I think we are trying to make sure that the culture here is one of making sure we are not wasteful, so whether it’s freight costs, FedEx costs, inefficiencies in terms of stock balancing we are looking at every way to increase productivity, and we believe that a lot of that is just simply focus on it.

David Mann - Johnson Rice

I guess sort of piggybacking on the last question, with the guidance for the rest of the year and sort of how things played out year to date, why would you not be more aggressive in terms of cost cuts at this point in time?

Betsy Burton

We want to make sure we don’t cut into the bond and I think we have looked at and do believe that there are some opportunities but that in particular with regard to the additional overhead that will be saved by eliminating redundancies and moving to a centralized merchandising organization. We can’t do that until we have got common product assortments otherwise you would have multiple assortments and the same number of bodies trying to do multiple assortments. So we believe it will be premature to look for cost savings for immediate return, in other words, this immediate second half of fiscal ‘07 the returns in terms of greater efficiencies will really be fiscal ‘08 and beyond.

David Mann - Johnson Rice

In terms of the small growth of stores you have, I mean can you just talk about your philosophy about growing it all at the point where perhaps your balance sheet that drives in a little bit of pulling back CapEx?

Betsy Burton

We’re really not pulling back on our real estate growth. It will be predictable growth year-over-year, and we are looking, however, we have tightened our financial hurdles and are being much stricter in the enforcements so that when we make capital decisions it’s not square footage growth for a growth sake. We are very disciplined in terms of look at the pro formas and what the CapEx is required.

I think as Rodney alluded to in some instances if there is a store, even if there’s a store that is up for renewal, if in fact it requires a full scale remodel it still has to pass the return on investment hurdle. So we are not pulling back from growth. In fact it’s anything we see great growth and great returns in particular on the new stores in the Peoples division and Mappins as well as in the Outlet division here.

So we will be focusing our real estate expansion on proven brands, in proven markets and but believe there still are great growth opportunities especially as you know with development of the lifestyle centers and some of the redevelopments of existing malls.

So in terms of capital expenditure we believe that it will be short sighted and we are again focused on long term. So we are continuing to make those investments and as you know in light quarters, like the quarters the three and four obviously a new store doesn’t necessarily pull its way, but we believe long term we obviously are committed to growing appropriately.

David Mann - Johnson Rice

One last question I think probably everyone on the call is asking themselves, last summer you guys were approached by your major competitor. Are they seemed to still be open to talking to you at least trading between some of your public comments? Can you just talk about with more time under your belt, under what scenario or timetable might you as company being more willing to consider going down in that strategy of having talk?

Betsy Burton

I don’t think it’s a matter of having more time under the belt because I clearly still see the opportunity as I did this time last year. Yeah, we made a few mistakes. We know we’ll do differently and I think because of that I feel confident that we know what we need to do to turn it around. So I want to separate out us turning around the company from a decision to engage in conversations about a possible combination. As you know the conversations about a possible combination would not have been in our opinion in the best interest of our shareholders. We are always open to and always entertain opportunities to create value for our shareholders.

David Mann - Johnson Rice

Thank you very much.

Betsy Burton

Okay. Thank you.

Operator

Your next question comes from the line of Jeff Stein - KeyBanc Capital Markets.

Jeff Stein - KeyBanc Capital Markets

Okay. I just have quick follow-ups, guys. First of all, are you still selling the two-year warranty plan or is it being totally replaced by the lifetime plan and can you tell us what the attached rate is?

Betsy Burton

Yes, we are totally, the lifetime because we felt that it would be too confusing to offer two different offerings. It has increased about 25% from where it was as an attachment rate.

Jeff Stein - KeyBanc Capital Markets

Can you tell us roughly what your estimate is for the year? If you had $9 million bump, Well we can do math, if you had $9 million bump that would represent a 25% increase?

Rodney Carter

Hey Jeff, for the rest of the year it’s going to be roughly 20. $9 million is in the highest peak selling period.

Jeff Stein - KeyBanc Capital Markets

So 20 for the rest of the year?

Rodney Carter

I believe that’s the estimate.

Betsy Burton

Yeah the total of 30 annualized revenue is I think the number that we projected.

Jeff Stein - KeyBanc Capital Markets

That’s cash flow basically?

Rodney Carter

Yes.

Betsy Burton

Correct.

Jeff Stein - KeyBanc Capital Markets

This convergence in the merchandising organization, is this a strategy to save costs or to create more margin or do you see this as an incremental sales strategy, if so how?

Betsy Burton

Clearly it will be more efficient which means elimination of costs is certainly something that we expect it to happen. I think more importantly though it’s elimination of redundancies and also trying to really use the power of the entire corporation in terms of our relationships with vendors, suppliers. So in other words, we should be able to buy better again with our collective clout, and because that will be greater efficiencies for our vendors. So you can’t just look at it as overhead save, it’s really a save also in terms of additional buying power, buying clout, will avoid duplication of inventory. Right now we might have the same product being bought by three different brands and three different bands in the warehouse tying up three bunches of inventory. So again going to one band shared SKU, we should be able to also reduce our inventory but we keep here at the warehouse.

Jeff Stein - KeyBanc Capital Markets

Why should a customer shop Gordon’s instead of Zales and vice versa, a year from now?

Betsy Burton

Sure. I think if you go back to the fundamentals the real difference is in the people and the customer service and the customer relationship. It’s no different if you were to walk into – in fact all of our research would indicate, if you look to find out from each of the competitors as well as ourselves they wouldn’t know what store they are in. Their experience is typically you have to have the right product assortment and you have to have the right price but the missing and the magic ingredient is the associate and their ability to relate with that associate.

So we clearly feel that there is a significant moderate jewelry business in the mall. The market share is there. So having both of our brands with the same assortments is no different than having a competitor occupy that space. So we believe very clearly there is market share to be had, if we don’t have a Gordon’s there some other competitor will take that space and they will have whatever market share they are able to garner. So we clearly see the market, the businesses there.

When you walk into a Gordon’s it won’t feel like a Zales. We are not changing the look and feel day, use different elements, they merchandise buys and yet they don’t use signage in their showcases to the extent that Zales does. So you really if you are to walk into a Gordon’s and into a Zales you really would not know they have a shared product assortment.

Again there will be this 30% or whatever the number ends up being that does is unique to Gordon’s that won’t be in Zales store. And you know again differentiating through unique SKUs is something that we will continue to do as well as versioning for, especially for our ethnic stores.

Jeff Stein - KeyBanc Capital Markets

Thank you.

Operator

At this time, there are no questions.

Betsy Burton

Thank you, operator and thank you all for joining us for our call.

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Source: Zale F2Q07 (Qtr End 1/31/07) Earnings Call Transcript
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