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Executives

Thomas A. Haubenstricker - Chief Financial Officer and Senior Vice President

Matthew W. Appel - Chief Administrative Officer and Executive Vice President

Theo Killion - Chief Executive Officer, President and Director

Roxane Barry - Director of Investor Relations

Analysts

William R. Armstrong - CL King & Associates, Inc.

Rick B. Patel - BofA Merrill Lynch, Research Division

David Wu - Telsey Advisory Group LLC

Zale (ZLC) Q1 2012 Earnings Call November 21, 2011 5:00 PM ET

Operator

Good afternoon. My name is Jamaria, and I will be your conference operator today. I would like to welcome everyone to the Zale Corporation's First Quarter Fiscal 2012 Earnings 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 afternoon, and thank you for joining is for the Zale Corporation First Quarter Fiscal 2012 Conference Call. I'm Roxane Barry, Director of Investor Relations. On the call today are Theo Killion, our Chief Executive Officer; Matt Appel, Chief Administrative Officer; and Tom Haubenstricker, Chief Financial Officer.

We have posted a slide presentation for today's call on the Investor Relations homepage on our website, zalecorp.com. Before we begin, I'll read our Safe Harbor statement.

Our commentary and responses to your questions on this conference call will contain forward-looking statements, including statements relating to our future goals, plans, and objectives. These forward-looking statements are not guarantees of future performance and a variety of factors could cause our actual results to differ materially from the anticipated or expected results expressed in these forward-looking statements.

Additional information concerning other factors that could cause actual results to differ materially from those contained in the forward-looking statements is available in our annual report on Form 10-K for the fiscal year ended July 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 EBITDA, which is defined as earnings before interest, taxes, depreciation and amortization. A second non-GAAP measure is adjusted EBITDA, which excludes charges related to store closures. We use these measures as part of our evaluation of the performance of the company. In addition, we believe these measures provide useful information to investors. Please refer to the appendix within the Investor Relations presentation for reconciliation of these non-GAAP measures to the most comparable GAAP financial measures.

I'll now turn the call over to Theo.

Theo Killion

Thank you, Roxane, and good afternoon. Before I begin discussing the business in the quarter, I'd like to acknowledge and welcome Tom Haubenstricker, who Roxane mentioned during her introduction. Tom joined the company in October as Chief Financial Officer. He brings a broad range of finance, accounting and operational skills to Zale. He's a proven leader whose background includes rigorous financial management in turnaround situations. Most recently, Tom was a managing director at Turnberry Advisors and before that, he spent 24 years at Electronic Data Systems in a variety of finance and strategy leadership roles.

Other recent senior leadership appointments include Brad Furry, who joined us in September as Senior Vice President, Chief Information Officer; and Subha Ramesh, who came on board in late October as Senior Vice President of Real Estate. Brad has over 25 years of experience in leading and leveraging information technology in order to support and enhance business objectives. His 21 years of retail experience at Neiman Marcus Group will be invaluable, as we thoughtfully invest in our information technology infrastructure.

As we evolve our real estate strategy from one of primarily divesting to one focused on maintaining and growing our portfolio, Subha Ramesh is the right executive at the right time. She joins us from Hilco Real Estate, where she was a Senior Vice President. And before Hilco, she spent 8 years at Limited Brands, managing a diverse real estate portfolio across multiple divisions.

With over 25 years of experience, Subha will help us to frame and execute a multiyear plan for fleet optimization and growth. Tom, Brad and Subha join Jeannie Barsam, Senior Vice President Merchandise Planning and Allocation; and Toyin Ogun, Senior Vice President Human Resources and Customer Service, both of whom joined Zale earlier this year.

With the addition of these accomplished executives, we can accelerate building the skills, infrastructure and capabilities necessary for creating a strategic framework for long-term growth. Welcome, Tom, Brad and Subha.

Now I'd like to talk about our business results. For those of you following along on the slides that we posted on our website, you can reference my comments beginning on Slide 3. Today we reported a comparable store sales increase of 5.8%, representing our fourth consecutive quarter and 13th consecutive month of positive comps. The 300 basis point improvement in gross margin to 53.5% and the gross margin dollar increase of $22.6 million is a reflection not only of the price increases that we took in July and October, but an ongoing discipline to resist promotions or discounting that aren't a part of our plan for marketing approach that supports our financial objectives. The quarterly results that we reported underpin the work that we've been doing to stabilize the business and return to profitability.

Today our core merchandise assortment is at 85%. It's comprised of product that is predictable and replenishable. Product that reflects category margin and turning characteristics in line with or above category averages. Having achieved our stated goal, we will continue to manage and grow the core not by increasing penetration, but by continually testing new products and introducing new product if it exceeds our margin and turn requirements, or if it augments or elevates our core assortment.

This brings us to the introduction of the Vera Wang, Jessica Simpson, and Persona collections that we announced on our last call, which are highlighted on Slide 4. These brands provide differentiated product that enhances and elevates our emotional connection with our guest. Each brand is being supported by marketing campaigns online, in-store, on television and in print.

Vera Wang hosted a press party in New York this month during bridal week to unveil her new bridal collection available exclusively at Zale's. After the press party, there've been numerous editorials and blogs talking about the beauty and the affordability of the product.

Jessica Simpson recently twitted to 4.3 million of her fans about her exclusive jewelry line at Zales. The power and celebrity of these 2 important designers enhances our brand, and their diamond jewelry collections support our commitment to being the Diamond Store.

Overall, early results have been encouraging and have improved as we've begun our holiday marketing campaign. On Page 5 of the deck, you'll see a few images from this year's marketing campaign. I encourage you to visit our zales.com homepage to see a montage of our commercials and to see our 30-second spots. If you do, you'll join the more than 165,000 people who've seen our montage on YouTube over the last 2 weeks.

We believe that television advertising is important, and we're investing more on TV year-over-year. To be truly relevant, we believe you have to have a fully integrated marketing campaign, one that leverages TV, magazines, catalogs, insert, in-store, online display, search and social media. Rich Lennox and his team have created a campaign that portrays a one-eyed view of Zale so that whenever, wherever and however our guests access our brands, there will be a consistency of messaging that reaches to our aspiration of being the Diamond Store.

Turning to Slide 6. The third pillar that supports our goal of returning to being the Diamond Store is our ability to engage our guests in our stores. We've made significant investments in training our store's teams in order to provide interactions based on building relationships, not just closing a transaction. In addition to the Diamond Council of America training that we've talked about on past calls, we provided important product training to support our launches of Vera Wang, Jessica Simpson, and Persona. We've also launched an internal Facebook page that allows our store's team to share selling successes, selling tips and motivational stories.

A recent post is from a young man who came into our store to select the perfect expression of his love for a woman that he wanted to marry. A man of modest means, he didn't have the money to pay for the Vera Wang LOVE engagement ring that he believed his wife-to-be deserved. So he sold his truck and said to the jewelry consultant, "I love that truck, but I love her more." An amazing story, and now our stores' teams have the ability to inspire, educate and motivate each other in realtime. Our educational model is no longer just top down; it's peer-to-peer and therefore much more sustainable.

We've also introduced an important financing option that will allow even greater accessibility to our brands. In September, we rolled out an alternative credit program in the United States. This program is a safety net that allows some guests who do not qualify for financing through our primary city credit program to purchase at Zales, Gordon's and at our Zales outlets stores. I've been in 7 markets in the last several weeks, and our stores are excited not only about the quality of our product and the alternative credit program, but also about our strong in-stock positions. Our inventories are at planned levels, and we have the merchandise that we need to satisfy our guests this holiday.

Before I ask Matt to talk about the changes we've made to warranty revenue recognition, I'd also like to reference Slide 7. What you'll see there are key initiatives intended to anchor the work that we're doing to turn around the business. We accomplished what we intended to do in 2011, and we're making solid progress on our goals in 2012.

What you'll see as you read through the 3 years of initiatives is a focus on consistency and continuous improvement. We're committed to improving product, investing in our people, connecting with our guests and improving the financial profile of our business. Those themes won't be changing.

I'll now turn the call over to Matt, who will begin on Slide 8.

Matthew W. Appel

Thank you, Theo, and good afternoon to everyone. Before I turn the call over to Tom to walk you through the first quarter's financial results, I want to address the change and recognition of warranty revenue from our lifetime product, as effective in the first quarter of fiscal 2012.

Please turn to Slide 8. First, a little history on our lifetime warranty product. We began selling lifetime warranties on Fine Jewelry 5 years ago in October 2006. The lifetime warranty product replaced the 2-year warranty product. Accounting literature, more specifically ASC 605-20, revenue recognition for services, requires the recognition of warranty revenue and proportion when the warranty fulfillment costs are incurred, provided there is a sufficient pattern or history with respect to such costs.

In the absence of a history of fulfillment costs, the accounting standard requires the use of a straight-line recognition. Since inception of the lifetime warranty program, we have recognized revenue on a straight-line basis over a 5-year period. As of this quarter, we have sold Lifetime warranties for a full 5-year period. We've analyzed warranty fulfillment costs incurred over this 5-year period and now have sufficient cost history to recognize revenue in proportion to cost incurred.

More specifically, the cost history indicates that the majority of warranty fulfillment costs are incurred within the first 2 years of sale when most manufacturing defects surface. The lifetime warranty also covers ring sizing, including the initial sizing that typically occurs when purchased. We have concluded that lifetime warranty revenues should now be recognized over an 8-year life versus the prior 5-year life. This more conservative life will allow for warranty fulfillment costs that we expect to incur following year 5.

Turning now to Slide 9, I'll cover the implementation of the new warranty revenue recognition in more detail. Beginning with the first quarter of fiscal 2012, revenue from lifetime warranty sales will be recognized in proportion to the pattern of costs incurred over an 8-year life. Approximately 60% of the revenue will be recognized in the first year following sale of the warranty, approximately 12% will be recognized in the second year. The remaining 28% will be recognized in years 3 through 8. Keep in mind that we will periodically review fulfillment cost trends and modify, if material, the recognition percentages as well as the recognition period.

Deferred revenue related to lifetime warranty sales, which stood at $224 million as of August 1, 2011, will now be recognized in proportion to the remaining expected warranty costs on a prospective basis, utilizing the 8-year life. For example, the deferred revenue balance on a Lifetime warranty sold 2 years ago will be recognized over the next 6 years rather than 3 years under the previous methodology.

What this means is that deferred revenue that we entered this fiscal year with will be recognized more slowly than it would have been before the revenue recognition change. The net impact of the warranty revenue recognition change on our first quarter 2012 results was an increase of $6.3 million to revenue and an increase of $6.3 million or 85 basis points to gross margin. The change also improved net loss per share by $0.18.

With respect to the future impact, this is dependent on 2 things. One, the amount of lifetime warranty sales made in each quarter and two, the trend that warranty fulfillment costs incurred. For the full fiscal 2012, we estimate that revenue and gross margin will increase by approximately $30 million.

We will continue to call out the impact of the revenue recognition change in each quarter of fiscal 2012.

Please note that what I have just discussed only relates to our lifetime warranty products. Our broader warranty offering includes a one-year product of Pagoda merchandise and beads, and a 2-year product on watches. Recognition of revenue on these warranty products, which make up approximately 10% of warranty sales, has not changed.

I would now like to turn the call over to our new Chief Financial Officer, Tom Haubenstricker, to cover the financial results for the quarter.

Thomas A. Haubenstricker

Thank you, Matt, and good afternoon, everyone. I'd like to start by saying I'm pleased to be part of the Zale team and look forward to working with all of you in sharing the progress we are making towards returning the company to profitability.

Let me now cover our first quarter fiscal 2012 financial results. I will start with Slide 10. Revenues for the first quarter were $351 million, an increase of $24 million or 7.3% compared to $327 million for the same period in the prior year.

The increase in revenues is primarily due to the growth in same-store sales that Theo mentioned. We also received a lift in revenue from increased warranty and repair sales, and from the change in warranty revenue recognition that Matt just covered. The increase from these sources was partially offset by the revenue reduction associated with the net decrease of 70 stores compared to last year.

Comparable store sales for the first quarter increased 5.8% compared to a decrease of 1.1% in the prior year. This increase in comparable store sales was driven by a 14% increase in the average price per unit sold, partially offset by a 6% decrease in the numbers of units sold. I should mention that both the average price and number of units sold metric excludes our Pagoda business.

This dynamic of an increasing average price per unit and a decreasing volume of units sold was expected when we implemented our price increases in July and October. Using constant exchange rates, which exclude the effect of the change from foreign exchange rates, comparable store sales increased 5.2% for the quarter.

The Canadian dollar strengthened 3% relative to the U.S. dollar as compared to last year's first quarter. Foreign exchange rate impacts on our first quarter earnings was not significant, as the rate differential impacted both revenue and cost.

We achieved gross margin for the quarter of 53.5% compared to 50.5% for the prior-year period, an improvement of 300 basis points or $22.6 million. As Matt stated before, the revenue recognition change related to warranty accounting improved our gross margin by 85 basis points. The remaining 215 basis point improvement was achieved primarily through a combination of recent price increases and lower merchandise discounts, partially offset by the impact of rising commodity costs. The reduction in merchandise discounts in the quarter as compared to last year is due largely to a lower level of clearance merchandise within our inventory. As Theo stated earlier on the call, our inventory now stands at 85% core compared to 75% in the prior year.

SG&A expense for the quarter was $200 million compared to $195 million in the same period in the prior year. The increase in SG&A expense was primarily due to higher staffing levels in critical functions at both the store and corporate level and higher marketing expenses, partially offset by lower rent expense due to a lower store count compared to the prior year.

Importantly, SG&A expense as a percent of revenue for the quarter at 56.9% was down from the prior year's percent of 59.7%, as we continued to leverage store and corporate expenses against a growing revenue base.

For the quarter, we posted other charges of approximately $500,000 compared to $1.1 million in the prior-year quarter. The amounts recorded in this line of the income statement consist of charges related to store closures.

For the first quarter of 2012, we posted a $20 million improvement in our operating results, recording an operating loss this quarter of $22 million compared to an operating loss of $42 million in the prior year's quarter. On a percent basis, our operating margin was a negative 6.4% compared to prior year margin of a negative 12.8%. This improvement of 640 basis points was primarily driven by both gross margin improvement and greater operating leverage on corporate and store level costs.

Interest expense for the first quarter of 2012 was $9.9 million compared to $55.3 million in the prior year. The prior-year quarter included a onetime charge to interest expense of $46 million, which resulted from an amendment to our senior secured term loan.

With regards to our current level of interest expense, the company will continue to closely monitor both our improving financial picture, as well as the external credit markets to assess potential opportunities for improving the economics associated with our debt structure.

In the first quarter of fiscal 2012, we recorded an income tax benefit of $700,000 compared to a benefit of $100,000 in the same period last year. Income tax benefits were primarily associated with our Canadian subsidiaries.

Our reported loss from continuing operations for the first quarter of 2012 was $32 million or $0.99 per share. In the prior-year quarter, loss from continuing operations was $97 million or $3.03 per share.

Please turn to Slide 11, where I've outlined the main drivers of our year-over-year improvement in our net loss per share from continuing operations. Starting with last year's results which was a loss per share of $3.03, I've been adjusted for the one-time interest expense item resulting from last year's amendment to our senior secured term loan, which negatively impacted last year's first quarter by $1.43.

We then have core business improvement realized this quarter contributing $0.43 per share, the main drivers of this improvement were revenue growth and gross margin improvement, partially offset by the modest increase in SG&A and other expenses. And finally, the change in our warranty revenue recognition improved net loss per share by $0.18, bringing us to the $0.99 loss per share we've reported this quarter.

Turning to Slide 12, I've provided a similar walk on our EBITDA results. Last year's result was an EBITDA loss of $31.2 million. This quarter, we saw EBITDA improvement of $8.9 million from top line growth and $7.4 million from gross margin improvement, partially offset by $4 million of higher SG&A and other spend. And then finally the change in warranty accounting increased EBITDA by $6.3 million, bringing us to the EBITDA loss of $12.6 million we reported this quarter, an improvement of $18.6 million over prior-year quarter.

Now please turn to Slide 13, as I take you through our balance sheet and liquidity. Inventory as of October 31, 2011 stood at $857 million compared to $834 million at the end of the first quarter last year. The increase of $23 million was primarily due to the impact of higher commodity prices on our inventory and additional merchandise purchased to fuel the higher level of expected sales activity.

As of October 31, 2011, the company had cash and cash equivalents of $30 million compared to $25 million in last year's comparable quarter. At the end of the first quarter of fiscal 2012, the company had outstanding debt of $494 million compared to $450 million as of October 31, 2010.

In addition to the term loan of $140 million, long-term debt also includes $354 million borrowed under the revolving credit facility. The increase in debt compared to last year was due in part to the financing of additional inventory.

As of the end of the quarter, the company's total borrowing availability under the revolver stood at $207 million. Our net revolver availability adjusted for the $50 million minimum liquidity requirement stood at $157 million. Also important to note, we have recently completed our latest external inventory appraisal, which we anticipate will result in an increase to our liquidity by approximately $20 million beginning in January.

During the first quarter of 2012, capital expenditures totaled $4 million compared to $3 million in the prior-year quarter, and were devoted primarily to the refurbishment of stores and technology infrastructure investments.

I'm now going to cover the overall store count for the quarter. I should mention we have included a page in the appendix that now contains the current store count. We ended the first quarter with 1,156 Fine Jewelry stores and 665 kiosks, for a total of 1,821 retail locations compared to prior year first quarter count of 1,218 Fine Jewelry stores and 673 kiosks, for a total of 1,891 locations.

During the quarter, we closed 7 Fine Jewelry stores. We also opened one kiosk and closed 2 kiosks. Our expectation continues that we will selectively close a small number of stores that are underperforming if the economics makes sense and, over time, we will open new stores where the opportunity is compelling.

We still estimate we will close approximately 20 Fine Jewelry stores and 5 kiosks during the course of the current fiscal year.

Now please turn to the next Slide, #14. As I end my comments on the financial performance of the quarter, I thought it was important to look back at the progress the company has made over the past several quarters. As you can see, our trailing 12-month EBITDA, adjusted for charges related to store closures, now stands at a positive $32 million compared to negative $42 million one year ago, and a negative $118 million 2 years ago.

The management team fully understands there is still a significant amount of work ahead of us as we move toward our goal of a sustainable, profitable growth. But we believe we have the company positioned on the right path to achieving this goal.

I would now like to turn the call over to the operator to begin the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question will comes from the line of Rick Patel with Bank of America.

Rick B. Patel - BofA Merrill Lynch, Research Division

Could you break out your comp for the U.S. business versus Canada? And perhaps highlight any differences you see in the operating performance or how customers are reacting to your new assortment?

Thomas A. Haubenstricker

So we don't break out the division between the U.S. and Canada. Obviously we're focused on both regions to drive growth and additional profitability. But we don't break that split out.

Rick B. Patel - BofA Merrill Lynch, Research Division

Well then, can you talk a little bit more about your marketing plans for this holiday? Just perhaps highlight how much you're looking to invest, which marketing channels those dollars will go to and how that compares to last year?

Theo Killion

As you may know, Rick, there was -- depending on who you talk to, anywhere from a 12% to 15% television increase in terms of the buy. We're actually pretty proud of the fact that we were able to get good rates for our overall television. But the thing we're actually most proud of is the blended way that we're going after marketing this year. We are spending more money year-over-year on the television spend. But the place where we believe that the consumer is going is in all kinds of social media is in mobile. This year, for instance, mobile will represent about 20% of the traffic and 6% of the sales, which is double a year ago. We have 40,000 Facebook fans, for instance. I talked to you about the 165,000 people who have opted in to our commercial that we put online. The power of being able to have people talk about your brand and opt in versus pushing the advertising messages at them we think is very, very important. And so a lot of our investment is going there. I won't be breaking out where it goes channel by channel but directionally, we'll be continuing to ramp up a multi-marketing platform.

Rick B. Patel - BofA Merrill Lynch, Research Division

Great. And then can you just update us on how big your engagement category is today? And how much does Vera Wang represent within that category? And then separately, how big is the engagement business overall during the holiday season for Zale?

Theo Killion

The bridal business overall, not just the engagement business, is about 45% to 50% of the business. The diamond business, which is why we're focused so much on the Diamond Store, is as much as 75% or 80% of our inventory, includes a diamond. The Vera Wang and the Jessica collections in particular really just started at the end of October. So we wouldn't anyway give any specific information about those collections. But they're at the beginning of the beginning and as I've said, overall results for all of our collections have been encouraging.

Operator

[Operator Instructions] Your next question will comes from the line of David Wu with Telsey.

David Wu - Telsey Advisory Group LLC

First question, can you talk about how the comp progressed through the quarter and what you're seeing so far for November?

Theo Killion

In November, our comps are better than what we just reported for our quarter. But obviously, we're not going to give specific information for competitive reasons.

David Wu - Telsey Advisory Group LLC

Excellent. And secondly, can you quantify the gross margin benefit you received from the price increases versus the lower promotions? And whether or not you've also benefited from higher warranty sales as well?

Thomas A. Haubenstricker

So David, for competitive reasons, we're not going to quantify the impact, the exact impact of the price increases. Needless to say, that the combination of the price increases and the lower discounts, clearly were the main drivers to both offsetting the cost increase we saw, as well as driving the overall margin forward.

David Wu - Telsey Advisory Group LLC

Okay. And how did warranty sales fund this quarter?

Thomas A. Haubenstricker

So warranty sales, set the accounting aside, the warranty revenue was up around $5 million again, independent of the accounting adjustment.

David Wu - Telsey Advisory Group LLC

Great. And what was it last year?

Thomas A. Haubenstricker

It was up $5 million last year. I don't have the basic comparison between the amount last year.

David Wu - Telsey Advisory Group LLC

Great. And then with respect to the new alternative financing agreements, can you perhaps quantify the amount of incremental sales contribution from the programs in the quarter? And perhaps your expectations for the program going forward, especially as you potentially enter into more of these arrangements?

Matthew W. Appel

David, this is Matt. We're not going to be disclosing specific sales amounts related to the alternative financing program. But what I can say is that the program has started off in a very strong fashion. And to date, it's exceeded our initial expectations. And we're hoping to maintain that going forward. But credit matters in Jewelry. And this is another lesson in that context.

Operator

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

William R. Armstrong - CL King & Associates, Inc.

Just a follow-up on that last question with the alternative financing program. I know you just rolled it out in September. Any indication as to whether that might have a greater penetration among gift givers during the holidays? Or bridal or your bridal business?

Theo Killion

Bill, I think it will have an impact across the business. And so we're seeing both lower ticket and larger ticket purchases. So I think it's going to help at every price point. But I don't have a way to predict where it'll be most impactful.

William R. Armstrong - CL King & Associates, Inc.

Understood. The new warranty revenue recognition, I just want to make sure I understand what this $6.3 million positive impact actually represents. Is that what the increase in revenues under the new recognition policy versus what it would've been under the old straight-line 5-year policy?

Thomas A. Haubenstricker

That's correct, Bill.

William R. Armstrong - CL King & Associates, Inc.

Okay. And same thing goes for that $30 million prospective on improvement as well?

Thomas A. Haubenstricker

Yes, that's a similar number in terms of our estimate for the full year.

William R. Armstrong - CL King & Associates, Inc.

Okay. And then finally on same-store sales for the quarter, could you break out for us the comps for Fine Jewelry stores versus kiosks?

Thomas A. Haubenstricker

No. Again, we don't break that down on the call. So again, we're focused on obviously all those areas, but we don't provide that split.

Operator

[Operator Instructions] That is all the questions that are queued up for today. I will now turn the call back to management for closing remarks.

Theo Killion

We began planning holiday 2012 in January, and we've continued to refine the work as the holidays have drawn nearer. We're ready. The product, the marketing, our field teams, our online teams and those of us who support those teams here in Dallas are all ready. To our 13,000 employees and to those of you on the call, we wish you a happy, healthy and prosperous holiday season.

Operator

Ladies and gentlemen, that concludes the Zale Corporation's First Quarter Fiscal 2012 Results Conference Call. We appreciate your time. You may now disconnect.

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