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I listened and read Zale Corporation's (ZLC) 2nd quarter 2007 conference call on Wednesday, 21 February 2007. Zale's fiscal year end is July 31st. This is a follow-up of my previous article, previewing Zale's earnings.

I will provide an update to the earnings forecast table from my prior article. After, I will walk through the conference call and provide my commentary.

Earnings & Guidance

  • 2Q Earnings Actual (2Q Quarter–Jan 07): $1.94;
  • 3Q (3Q–Apr 07): $0.00 – $0.04;
  • 4Q (4Q –Jul 07): $-0.05 – $-0.01; and
  • FY (Fiscal Year): $1.46 – $1.52.
  • The company indicated that store comps for Q3 are expected to decrease 2% to 3% and for Q4 are expected to be flat to slightly positive. These figures exclude the impact of derivative accounting and the change from a two year to a lifetime jewelry protection plan. For the full year, the company is projecting total revenue growth of 3% and flat store comp growth after adjusting for Bailey Banks & Biddle store closures. Excluding the jewelry protection plan, the company is projecting an improvement in full year gross margins by 40 basis points to 52.2% compared to 51.8% for the previous year. The overall guidance is less than what the market expected and thus the stock sold off today, down $1.40 to $28.56 for a loss of 4.67%.

    There was an interesting exchange during the question and answer session between Brian Tunick from JP Morgan and Rodney Carter, CFO.

    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.

    From this brief exchange, we can see that the analysts are disappointed with the guidance.

    Margins

    From the conference call transcript:

    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.

    Later, in response to a question from Janet Kloppenburg, Betsy Burton provided additional commentary on the margins as follows.

    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.

    These quotes indicate that the competitive landscape remains challenging. The company is attempting to strike a balance between market share and pricing. A key question is, Can the company maintain its margins without giving up too much market share?

    Lifetime Jewelry Protection Plan

    At the company's Zales and Canadian stores, the company replaced its two year protection plan with a lifetime protection plan. This change affects the company's accounting in that, while more money is charged for the plan, less money during the initial years is counted as recognized revenue because of the longer amortization period. For the past quarter, the company recognized a loss of revenue of $15 million while generating a $24 million in deferred revenue. Thus, the company gained $9 million from having switched to a different protection plan. While this transition phase is underway, expected to be about three years, the company will show less revenue. After the transition period, the company will show an increase in revenue. All these machinations are simply accounting effects. The reality is that the lifetime protection plan is a huge plus for Zales.

    E-Commerce

    The company's e-commerce initiatives continue to gain traction. Holiday traffic was up 23% over last year, with conversions up 50% giving rise to total revenues up 75%.

    Average Selling Prices

    I will provide the last quarter average transaction prices as well as the year ago values in brackets.

  • Zales: $354 ($338);
  • Gordon's: $381 ($394);
  • Bailey's: $1,602 ($1,559);
  • Outlet: $395 ($380);
  • People's: $296 ($286); and
  • Pagoda: $43 ($41).
  • Tax Rate

    A quote from the transcript is as follows.

    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%.

    Quarter End Store Count

  • Zales: 790;
  • Gordon's: 285;
  • Bailey's: 73;
  • Outlet: 136;
  • People's: 187; and
  • People's II: 72; and
  • Pagoda: 810.
  • Zales plan to spend $90 million for the fiscal year to add 55 new jewelry stores.

    Inventory

    Merchandise inventory at January 31st was $1.1 billion, which was $161 million or 16.8% higher than last year's figure. This higher amount is the result of three primary drivers: First, $51 million in remaining clearance inventory; Second, $50 million are earmarked for holiday and future sales; and Third, $37 million are dedicated to ZAP (Zales Assembly Process).

    Valentine's Day

    The company reported that its Valentine's Day sales fell short of expectations. The shortfall was exacerbated by the storm during the last two days. As a note, I am always cautious when a company uses weather as an excuse.

    Promotional & Sales Strategies

    Throughout the call, the company referred to different initiatives that were underway to improve margins or sales or both in its various brands. I was left with the impression that the company is refocusing or reorganizing itself. I did not get the clear impression that the company has its strategy well articulated internally. That might be the nature of retail, one where the retailer must constantly evaluate and adapt to changing circumstances.

    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.

    I am a bit confused by the above quote. Zales had a strategy in the U.S., exported it to Canada and simultaneously forgot about it in the U.S., and will be soon reimporting into the U.S.? I am not sure I have a proper interpretation, but the key point is that Zales appears to have some issues to resolve. I will be watching to see if the company can better articulate its strategy in future conference calls.

    Information Not Discussed

    I was hoping the company would discuss its share repurchase plans. But given that the company guided lower than anticipated, I am guessing that share repurchase plans were not at the top of its list of to-do items.

    Summary

    Overall, I thought the conference call was weak in that the company lowered its forward guidance and that its strategies and tactics seemed to be in flux. Zales appears to be wrestling with its margins and market shares. The company's inventory levels are still causing it grief and that deserves further monitoring. Investors will need to wait to determine if some of the company's initiatives take hold and provide some upward momentum. On the positive side, the company's decision to switch away from a two year to a lifetime jewelry protection plan appears to be providing much more uplift than the company and investment community had anticipated. Because the company lowered its guidance and was unable to cleanly articulate its various strategies, I remain bearish on the stock.

    Disclosure: I am short Zale Corporation.

    Source: A Zale Short Reviews Its Conference Call