Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

TRANSCRIPT SPONSOR
Wall Street Breakfast

Zale Corporation (NYSE:ZLC)
F4Q07 Earnings Call
August 30, 2007 9:00 am ET

Executives

Betsy Burton - President, Chief Executive Officer, Director
Rodney Carter - Chief Financial Officer, Senior Vice President

Analysts

Adrianne Shapira - Goldman Sachs
Janet Kloppenburg - JJK Research
Jamie Shondik - Merrill Lynch
Jeff Stein - Keybanc Capital Markets
Melissa Otto - W.R. Hambrecht
Marc Bettinger - Stanford Group Company
William Armstrong - C L King & Associates
David Mann - Johnson Rice

Presentation

Operator

Good morning. My name is Hamilton and I will be your conference operator today. At this time, I would like to welcome everyone to the Zale Corporation fourth quarter and full year earnings conference call. (Operator Instructions) Ms. Burton, you may begin your conference.

Betsy Burton

Good morning and thank you for joining us for our fourth 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.

Rodney Carter

Our commentary and responses to your questions on this conference call will contain certain forward-looking statements, including statements related 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 April 30, 2007, as filed with the SEC.

In addition, we may present 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. Q4 results were in line with expectations. Comp-store sales decreased slightly, 0.5%, as trends improved post Mother’s Day, and a continued focus on maximizing gross margin dollars and good expense control resulted in pro forma EPS of $0.00, which was the high-end of our guidance.

Here are some of the highlights for the quarter: Zales, Gordon's and Pagoda comp-store sales declined in the low single digits, offset by continued strength in outlet, up mid single digit; People’s, up double-digits; and Bailey’s, up mid-single digit. Dot-com also continues its very strong double-digit increases.

Fashion jewelry for Zales decreased slightly while Gordon's saw an increase. People’s growth continued to be fueled by growth in diamond fashion and outlet had solid growth across all major categories.

The luxury segment performance at Bailey’s was in large part driven by double-digit increases in watches, diamond fashion, and semi-precious. Pagoda’s gold chain sales were off due to fashion trend changes that negatively impacted the sales of higher ticket, long, heavy link chains. This was somewhat offset by growth in diamond fashion and body jewelry.

Merchandise margins showed strong improvement over last year. However, year-end adjustments and the impact of derivative accounting resulted in a slight decrease in margin rates.

Good expense control resulted in a slight improvement in SG&A as a percent of sales compared to last year and sales of the new lifetime jewelry protection plan resulted in an incremental $10 million of cash for the quarter and $37 million of cash for the year.

Fiscal ’07 as a whole was a year in which we focused on going back to the basics. It marked the return of the Zale’s brand to its diamond store heritage, as well as middle America as its core customer.

We had the first positive holiday comp in the Zale's brand for three years. We [costed] investment spending and inventory assortments, as well as in payroll and marketing. While many of these initiatives paid off, others have been or will be paired back, and as we have mentioned before, we believe the Zale brand was priced too aggressively last holiday and see opportunity to refine our pricing and promotional strategy. We also see opportunity to better coordinate the promotional calendar for Zales and Gordon's.

But overall, I am pleased with the progress we have made to date in repositioning the Zale’s brand and are focused on an improved customer experience going into this key holiday season.

With regard to the other brands, we had strong comp-store increases in Canada and outlet, and dramatic growth in our dot-com business. And while comp sales were flat for the year, total revenues excluding ESAs, were up 2% due to new store growth and accelerated openings in Q1.

We also made significant in-roads in fiscal ’07 with regard to our direct sourcing initiative. The percent of sales of ZAP produced goods nearly doubled from 4.4% of sales to 8.5% of sales, and total direct sourced goods grew from 27% of sales last year to 35% this year.

And we launched several key systems initiatives to support the needs of the business, as well as to facilitate implementation of some of our strategic initiatives. We introduced an online vendor portal that allows vendors to view and set up new items online. We implemented year one of our three-year plan to install the Oracle merchandise planning system, and we are beginning a three-year rollout of a new and improved proprietary point of sale platform.

Now, on to fiscal ’08. Over the past year, we have looked at every aspect of our operational performance, looking to define and refine Zale's strategy for long-term success. We reviewed our portfolio strategy, the positioning of the various brands, as well as looked for opportunities to improve the core business.

Let me now talk about the three broad components of our strategy. First is a focus on improving our core mall business, where we believe we have significant opportunity to drive shareholder value. As you are aware, the core U.S. mall business is not a growth engine but it can be a huge free cash flow generator for us.

To capture this opportunity, we are working on several key initiatives. Improving the customer experience -- admittedly, this is an area where we have lacked focus in the past. We want to create a best-in-class customer experience. We’ve recently talked to customers to better understand their needs and dissatisfactions. We see improvements that can drive significant same-store sales growth both today and tomorrow.

Next, continue our direct sourcing initiative, where we see significant opportunity for both the diamond procurement and assembly operations, as well as for the direct importing of finished goods. We believe that long-term, direct-sourced goods can be 50% of sales.

We also see the opportunity to improve our supply chain strategy to drive cost-savings, and improve inventory management to significantly reduce inventory levels. To support our commitment to achieve these objectives, we recently appointed Gil Hollander to an expanded role of Group Senior VP Supply Chain and Chief Sourcing Officer.

And continued emphasis on return on capital -- this means putting a sharp lens on all real estate decisions and evaluating store-by-store performance based on return on capital. This focus applies to new and existing stores. We will close stores that are not meeting their cost of capital and where it is unlikely operational improvement would get it to hurtle up.

We will also scale back investment in new stores for the Zales and Gordon's brands until we have made progress in making operational improvements.

Where we will invest is where we can build on our successes in those brands and formats that produce the highest returns on capital. We will accelerate growth in Canada, where both People’s and Mappins have a significant stronghold, where we can leverage the infrastructure already in place and where there is plenty of headroom left for growth.

And while the focus is on the core business, we have not lost sight of the growth opportunity outside of the traditional mall. We want to build on our success with Zales Outlet. We have a proven, profitable and differentiated off-mall model and we will continue to ramp up its rate of growth.

And we will continue to build on dot-com success with focus on the online customer experience and multi-channel execution.

The last component of our strategy is the migration to a more centralized, streamlined organization. Earlier this month, we began consolidating support functions across the moderate brands, including the move to centralized merchandising. Buying for Zales, Gordon's, Outlet and Canada will now be combined under the leadership of Steve Lang, Group Senior VP and Chief Merchandising Officer.

Operations for the Gordon's brand has now been consolidated under Z&A operations, as we move toward a mall-based division and an all off-mall division in the future.

Through extensive analysis of our transaction data, it is very clear both the Zales and Gordon's brands serve the same customers and occasions. There is little justification to split the brands completely apart. It is very expensive to change customers and there does not appear to be a large enough missed segment to justify going after. So while we will migrate to a greater percent of common SKUs, we do believe we can differentiate the brands on experiential dimensions that leverage the roots of each brand and deliver on customer needs. Both can deliver a superior customer experience just with different points of emphasis.

The position of brand president has been eliminated, beginning with the moderate brand. We believe there are significant synergies and efficiencies to be gained by the elimination of redundancies and more teaming across brands. While we believe there will be significant savings over time, we believe the near-term benefit is an organization that can be more effective by better leveraging our best practices and best people. This means better decisions, quicker decisions, the ability to stay nimble, and working together as one team.

So to recap, we are focused on creating shareholder value through operational improvements to the core business, driving free cash flow and increasing returns on capital.

Now on to guidance for fiscal year 2008; for the year, we are planning growth in comp-store sales, including dot-com, of up 1% to 2%; normalized EPS growth of approximately 15%; and a return to strong free cash flow of approximately $125 million to $150 million.

I would now like to ask Rodney to review the financials and quarterly guidance, and then we will open up the call to questions.

Rodney Carter

Thank you, Betsy and good morning, everyone. Following are the key statistics for the fourth quarter of fiscal 2007: total revenues decreased 0.5% for the quarter and were essentially flat for the year. Total revenues for the quarter were negatively impacted by a decrease of $7.5 million as compared to the prior year in recognized revenues from the sale of lifetime jewelry protection plans or warranties. Actual cash sales of warranties increased to $26.7 million versus $16.6 million in the fourth quarter last year.

Comp store sales decreased 0.5% for the quarter and 0.2% for the year. Comparable store sales by brand for the year were: Zales, negative 1.5%; Gordon's, negative 4.1%; Bailey Banks & Biddle at positive 0.1%; Outlet, up 4%; Canada or People’s, up 10%; Pagoda, down 2.4%; again, for a company total of down 0.2%.

The average transaction for the quarter by brand was as follows: Zales, up 2.3% to $388; Gordon's, up 2.6% to $435; Bailey’s at $1528 was down 6.9%, due to the increase of the highly successful sale of the Susan B. Komen fund-raising product; Outlet was up 5.1% to $429 per transaction; People’s was up 8.1% to $301; and Pagoda was flat at $36 per transaction.

As discussed in our second quarter call, we extended the service period for jewelry protection plans offered to our customers from two years to the lifetime of product ownership, while simultaneously raising the retail price on these plans. The customer response continues to be favorable as our attachment rate has increased from 42% to 50%, and cash sales at the store increased $9 million during the quarter and $33 million for the year.

While cash warranty sales at the stores increased, revenues recognized were negatively impacted as the company changed form a proportion of two-year recognition period based on the historical service patterns for the two-year protection plan, to a straight line amortization period over five years for the new lifetime protection plan.

The estimated impact to the fourth quarter is $10.3 million, and $36.6 million for the year, had revenue been recognized on a basis consistent with the historical methodology.

As stated for the year, total cash sales of warranties increased $33 million to $111 million in fiscal ’07, from $78 million for the prior year. In contrast, revenue recognized has decreased $26 million to $48 million in fiscal 2007 from $74 million in fiscal 2006.

Because fiscal 2007 earnings estimates were based on sales of our two-year agreement, we believe it is meaningful to investors to reconcile our fiscal 2007 results under GAAP with the estimated impact of revenue recognition for warranties on a basis consistent with our historical methodology.

Using consistent methodology, we estimated the impact on EPS to be $0.13 and $0.46 for the quarter and year-to-date periods, respectively.

In fiscal 2008, we will continue to disclose in our footnotes and our press release the gross warranty sales of service agreements and the increase in unrecognized revenues on the balance sheet. We believe this will provide consistent insight into the continued cash generated from these sales and the impact on future earnings as the sales are eventually recorded as revenue.

Though there is an intermediate term negative impact on EPS as a result of the product change, the increase on our balance sheet in unrecognized revenues of $62 million represents immediate additional cash flow and longer term, an incremental increase in revenues and profits.

Since the related servicing costs are expensed as incurred, the current increase in unrecognized revenues equates to approximately $38 million after taxes, or nearly $0.80 per share to be recognized during the next five years.

I will discuss this impact on 2008 at the end of my comments. The product shift and timing of JPP revenue recognition also impacted the comparability of historical and mid-term forward-looking rates of cost of sales and SG&A as a percent of total revenues.

The delay in recognized revenues related to warranty sales of $7.5 million for the quarter and $25.9 million for the year resulted in a 70-basis point and 50-basis point decrease in gross margin for the quarter and the year, respectively.

This impact offset positive merchandise margin gains from direct sourcing in the quarter. The revenue decline resulted in a 70-basis point and 50-basis point increase to SG&A as a percent of revenues for the quarter and the year respectively.

We will experience similar impacts in the first half of fiscal 2008 but we will see rate improvement beginning in the second half of the year through 2011 as the revenues recognized reflect a five-year normalized level.

Operating loss for the quarter was $4.7 million. The prior year operating loss was $36.7 million, which includes $40.7 million of a non-cash charge in other items, and a $1.7 million derivative loss.

Operating earnings for the quarter on a basis consistent with guidance and prior years, including hedge accounting for commodity contracts and accelerated revenue recognition from the sale or warranties, is $3.8 million, or 0.8% as a percent of sales versus $5.7 million last year, or 1.2% of sales, excluding the impact of the mostly non-cash charge and derivatives loss.

For the year, on a GAAP basis, operating earnings were $103.1 million compared to $81.1 million last year, which includes the non-cash charge settlement of retirement benefit, Bailey Banks & Biddle store closures, and other items.

The effective tax rate for the quarter was impacted by an $8.5 million benefit from the election under APB to indefinitely reinvest Canadian earnings outside the United States. The benefit was partially offset by annual adjustments and the settlement of state tax audits.

Excluding the impact of APB-23, the effective tax rate for the year was 39.7%.

Under GAAP, net income for the quarter was $1.5 million, or $0.03 per share, versus a net loss of $27.4 million, or $0.57 per share last year. Net income for the quarter was $20,000, or $0.00 per share, including the following items after taxes: $1.1 million hedge accounting expense; $6.3 million estimated revenue recognized on a basis consistent with historical results; and a $6.7 million net benefit primarily related to Canadian taxes.

This compares to net income of $959,000, or $0.02 per diluted share last year, which excluded the following items after tax: $23.9 million non-cash charge for inventory and other asset impairments; $1 million derivative accounting expense; and $3.4 million other rent and tax related adjustments.

For the year, net income was $59.3 million, or $1.21 per share, versus $53.6 million, or $1.09 per diluted share last year. Net income for the year under hedge accounting and including warranty revenue recognized on a basis consistent with historical results was $74.4 million, or $1.52, compared to $90.9 million, or $1.85 last year, excluding the non-cash charges derivative accounting settlement of retirement benefit and Bailey Banks & Biddle store closures.

During the quarter, we opened nine stores and two kiosks. We closed seven stores and 32 kiosks, principally People’s carts in Canada as we completed our exit from this business. We remodeled and refurbished 29 stores and 10 kiosks in the quarter.

We ended the quarter with 2,264 locations as follows: Zales, 789 locations; Gordon's, 282; Bailey Banks & Biddle, 70; Outlet, 137; People’s, 193; and Pagoda, with 793 locations.

Merchandise inventory at July 31st was $1.02 billion, or 13% higher than last year at $903 million. The increase in inventory was slightly less than the end of the second and third quarters. The Zales brand has approximately $30 million remaining of the clearance merchandise identified at fiscal 2006 year end.

We continue to focus on clearing out this inventory, including leverage the other brands’ capacity where appropriate. In addition, the brand has $50 million related to excess inventory from expanded assortments. These items represent a broadening of the assortments in key categories and are consistent with brand positioning.

We feel we have sufficient open to buy to support the needs for appropriate depth in current bestsellers and infuse fresh assortments, while remaining committed to reducing inventory levels post holiday.

Inventory turnover on a rolling 12-month basis was 1.09 times versus 1.26 times last year. This decline reflects the increased investments.

Accounts payable and accrued liabilities were $40 million lower than July 31, 2006, primarily attributable to the decline in current merchandise payables as the brands work through existing overstock items and the reduction in severance obligations outstanding in the prior year.

We ended the quarter with $38 million in cash and borrowings of $227 million under the line of credit, compared to $43 million in cash and borrowings of $203 million last year.

The result of the increased inventory levels and the decline in current receipts in merchandise payables is both increased borrowings and a significant reduction in free operating cash flow. 2007 free cash flow was a negative $48.9 million.

Betsy highlighted our business strategy and objectives for fiscal 2008. Comparable store sales are expected to be 1% to 2%, including dot-com sales in the calculation. Beginning in fiscal 2008, we will include our online sales in the comp-store sales calculation.

This approach is consistent with our goal of improving our multi-channel experience and leveraging the best of our real estate footprint with the growth in online sales. Comparable store sales for 2007, including online sales, were 0.5%. Quarterly breakdown of comparable store sales for fiscal 2007, with dot-com included, was provided in today’s press release.

As we stated earlier, our decision to offer a lifetime jewelry protection plan has been well-received by our customers. Actual cash sales of all warranty plans were $111 million in fiscal 2007 and are projected to exceed $130 million in fiscal 2008. Despite this increased cash sales, the amount of unrecognized or deferred revenues will also increase.

During fiscal 2007, we provided the impact of the change to a lifetime product by estimating what revenue would have been under the prior pricing and at prior revenue recognition rates. This was consistent with initial guidance.

Going forward, we will discuss the impact on earnings relative to the change in unrecognized revenues on the balance sheet, which reflects the incremental cash collected and the future positive impact to earnings. We feel this will be clearly and readily quantifiable to the shareholder.

Our GAAP growth in 2008 EPS of approximately 5% continues to be impacted by the recent change in the product and related revenue recognition. On an adjusted basis, including the change in unrecognized revenues from warranty sales, the company’s growth in fiscal 2008 is expected to be approximately 15%.

Beginning in 2009 and through 2011, the gross growth is expected to accelerate to approximately 30% as we recognize incremental revenues each year and the balance sheet continues to increase. Approximately one-half of this growth is directly related to the change in warranty product and related revenue recognition.

In order to estimate a more normalized year-over-year growth upon maturity of the product, we believe considering the increase in the unrecognized revenue is the appropriate measure.

The increase in unrecognized revenues on the balance sheet was $62 million in fiscal ’07 and is anticipated to be approximately $80 million to $90 million in fiscal 2008. In contrast, the increase from 2005 to 2006 prior to the product change was $3 million.

Had we been offering this product for five years, these amounts are indicative of what would be recognized on an annual basis and the after-tax impact would be an increase of $0.78 per share in 2007 and projected to be an increase of approximately $1 per share in fiscal ’08.

The incremental impact of these unrecognized amounts is expected to decline in fiscal 2009 through 2011 as the amounts of revenue recognized becomes comparable to cash sales of the plan.

On a GAAP basis, we estimate earnings in the range of $1.11 to $1.16. Excluding the $6.7 million or $0.14 benefit from the adoption of APB-23, fiscal 2007 earnings would have been $1.07 per share. These earnings do not reflect the longer terms earnings benefit of the lifetime warranties.

The APB-23 tax election resulted in a cumulative benefit of $8.5 million, or $0.17 per diluted share, in fiscal 2007. This amount reflects a true cash flow benefit and a go-forward reduction in the effective tax rate equating to approximately $0.03 per share annually.

The estimated tax rate for fiscal 2008 is 37%. Including the impact of the increase in the unrecognized revenues on the balance sheet, earnings would be $2.11 to $2.16 in fiscal 2008 compared to $1.85 in fiscal 2007, as adjusted for the impact of APB-23. This reflects earnings growth in the mid-teens, consistent with our long-term targets.

Over time, the lifetime warranties will accelerate our GAAP earnings while the change in unamortized revenues on the balance sheet declines.

I will now touch on guidance for the first two quarters of fiscal 2008. For the first quarter, we expect EPS to be at a loss of $0.59 to $0.63, compared to a $0.55 loss last year. The decline reflects the decrease in revenue recognition, which more than equals the loss from derivatives in fiscal 2007. In the second quarter, we estimate earnings to be $1.85 to $1.91 per diluted share, compared to $1.80 per diluted share in the second quarter of fiscal 2007. We will continue to have a negative near-term impact from the JPP revenue recognition.

The capital expenditure plan is approximately $105 million for the fiscal year, with a total target of 37 new jewelry stores, primarily in People’s and Outlet brands, 10 new kiosks and $15 million to $20 million in the IT-related infrastructural investments Betsy mentioned earlier.

On a normalized basis, we believe our initiatives will deliver sustainable earnings growth of 15% and significant positive free cash flow.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Adrianne Shapira of Goldman Sachs.

Adrianne Shapira - Goldman Sachs

Thank you. Betsy, could you talk a little bit about just again the holiday strategy? It sounds as if curtailing promotions compared to last year, so perhaps help us understand this trading sales for profits as we head into the holiday season.

Betsy Burton

I speak primarily with regard to our pricing strategy and in particular the percent of our sales which were in our brilliant buys. So it is really more of a pricing strategy, Adrianne, then a promotional strategy. We are anniversarying all of the promotions that we had last year, other than some of the events which were unadvertised where we believe we did not necessarily need the promotion. So it is really not a -- there really will be very little visible change to the customer in terms of promotional activity.

Adrianne Shapira - Goldman Sachs

Following on that, since it sounds as if perhaps it’s not as promotional to work down some of the excess inventories that you’ve got heading into the holiday season. I’m just wondering, help us understand the inventory assumptions, turnover in your CFO guidance of the $230 million to $255 million, which clearly is a market reversal from the last few years.

Betsy Burton

In terms of holiday in particular, we believe that we do not want to trade regular sales for clearance sales, so typically we are conservative in terms of not pushing an additional percentage off clearance, so we do believe that we can take out $50 million worth of inventory for the year. It is just during the critical holiday quarter, we believe it is important also to sell regular price goods and maximize gross margin.

Adrianne Shapira - Goldman Sachs

So just as Rodney, I guess you had mentioned, the turn had decreased from 1.26 to 1.09 times, you are looking for an improvement in turn and how you are thinking about inventory ending next year to get to that CFO level?

Rodney Carter

The two numbers were ’06 to ’07 and we do expect, we didn’t comment on what our turn number would be at the end of this year but Betsy talked about the flow-through of expecting a relative decrease in inventory of approximately $50 million for the year.

Basically, we have an advanced stock of some of the items that are core product that don’t necessarily have to be replenished, so we’ve got an opportunity to work through and decrease inventory.

Adrianne Shapira - Goldman Sachs

Okay, and then just a last point on the comps; you talked about 1% to 2% inclusive of the online business -- give us a sense of how much that adds to your comps and what does that suggest in terms of the underlying comp trend?

Betsy Burton

It added about 0.8, Adrianne, for ’08 and it was about 0.7 for ’07, so as it becomes an increasingly important part of our strategy, we recognize that some of the sales come at the expense of the brick and mortar stores, so we believe it is more appropriate to look at the combined, especially as we have several initiatives in terms of enhancing our multi-channel experience and execution. So it is becoming an increasingly part of our business and our strategy.

Adrianne Shapira - Goldman Sachs

Thank you.

Operator

Our next question comes from Janet Kloppenburg of JJK.

Janet Kloppenburg - JJK Research

I have a number of questions. First of all, Rodney, on the second quarter guidance, just the simple numbers you just gave of 185 to 191 versus 180, could you give us an idea of the increase in revenue recognition you are assuming in that so we could somehow get to -- because I think the revenue recognition level will be on the warranty sales will be lower this year than it was last year -- on the lifetime guaranty sales, excuse me. So I am trying to adjust what the real EPS guidance looks like for the quarter. Do you understand my question?

Rodney Carter

It may be one that is worth doing offline but the point is as we lap this, there will be a significant decline in revenue recognized because we just launched in one brand during a portion of Q2 last year and hadn’t launched the lifetime JPP product for some of the other brands --

Janet Kloppenburg - JJK Research

That’s what I mean. There will be a significant loss this year in the second quarter versus last year, is that correct?

Betsy Burton

In terms of recognized revenues, that’s correct.

Janet Kloppenburg - JJK Research

Right, so is that included in this guidance, the loss of revenue recognition versus the prior year?

Betsy Burton

It is.

Janet Kloppenburg - JJK Research

It is. So can we get an adjusted outlook? Is it 15%?

Rodney Carter

It is about a $0.48 amount of unrecognized revenue that will be put on the balance sheet during that quarter. Out of the $1 or so that we talked about, $0.48 would be just in that quarter alone.

Janet Kloppenburg - JJK Research

Okay, well, we can talk about it offline. But the other question I had for Betsy is with respect to the centralized merchandising strategy; can you give us an idea for this holiday season how much product will be the same product, Gordon's and Zales, as opposed to last year? What percentage you want to maintain as exclusive products to each brand?

Betsy Burton

We currently expect to have about 40% of the SKUs in common from holiday. That is up from about 20% last year. Long term, we believe the number will be in the range of 80% to 90%, the common SKUs, so call it 10% to 20% exclusive to the brand.

Janet Kloppenburg - JJK Research

And so will the pricing be the same as well in all of the stores?

Betsy Burton

We are moving towards a more unified pricing, that is correct.

Janet Kloppenburg - JJK Research

Okay, but not necessarily this holiday season?

Betsy Burton

Again, it will be over time.

Janet Kloppenburg - JJK Research

And what will happen with the marketing programs, given that the product lines have become very similar to each other?

Betsy Burton

The marketing programs, clearly they both have their unique marketing campaigns. That will continue, so there will be a different look and feel to the ads but they will be very similar to last year’s for both Zales and Gordon's in terms of their creative. The advertised product on TV will clearly be different product, so again to the customer it will look very much like two different brands and two different strategies.

Janet Kloppenburg - JJK Research

Have you guys delineated the cost savings of centralizing these organizations?

Betsy Burton

Well, we look at it not just cost savings. We have dollared it out but the real initial opportunity is in leveraging our buying power and consolidating our purchases, so I think it is more from a standpoint of not necessarily savings from G&A but savings in terms of cost of product, so we are not looking for a big save and we also have to be a little bit patient in terms of we have some systems initiatives to support a centralized merchandising organization that are not yet completed. So again, the real benefit would be better coordination, better consistency in terms of the product assortment, and longer term there would be some savings in terms of SG&A.

Janet Kloppenburg - JJK Research

So Betsy, it is not a dramatic headcount reduction as a result of this program?

Betsy Burton

No, no.

Janet Kloppenburg - JJK Research

Okay, and just lastly on the inventory front, it is my impression that there is still some carryover of core, or let’s say discontinued product at Zales that’s remained in the content of the inventory. Is that correct, Rodney?

Rodney Carter

Yes, there is about $30 million.

Janet Kloppenburg - JJK Research

And how long will it be before you anticipate that that will be liquidated?

Betsy Burton

We look at that in the next probably 12 months, 12 to 18.

Janet Kloppenburg - JJK Research

And the value of that inventory I assume has been written down to --

Betsy Burton

Yes, we have a reserve on it.

Janet Kloppenburg - JJK Research

Okay. Many thanks and good luck for the holiday season.

Operator

Our next question comes from the line of Lorraine Maikis of Merrill Lynch.

Jamie Shondik - Merrill Lynch

Hi, this is Jamie [Shondik] for Lorraine Maikis. I was wondering if you guys could talk a little bit more about product for holiday and I guess what are the biggest changes we should see at the Zale brand?

Betsy Burton

Actually, the big item is still Journey. As you know, that was introduced by DeBeers last year in their television advertising and again, that is anticipated to be the hot item of the season. We don’t see any dramatic new product. I think again our assortments reflect what we know sold last year and clearly the hot items last year will probably continue to be the hot items for this year. So there is really not a lot in terms of change in product assortment or strategy for this holiday.

Jamie Shundyck - Merrill Lynch

Okay, and then just a quick question on the free cash flow; I was just wondering if you guys could talk a little bit more about how you plan to get to that free cash flow estimate for ’08 and what the biggest changes are versus this year?

Rodney Carter

Well, I think the biggest -- there are a couple big turnarounds. One is the $50 million reduction in inventory alone, and as we replenish and buy replacement inventory, we also have significant increases in accounts payable in a normalized use in just cash flow, so a big chunk of it is just the inventory and the normal buying process.

Betsy Burton

And then of course the incremental cash from JPP.

Jamie Shundyck - Merrill Lynch

Great, thanks.

Operator

Next we have Jeff Stein of Keybanc Capital.

Jeff Stein - Keybanc Capital Markets

Betsy, I’m wondering if you guys first of call can disclose what your Internet sales are now, given the fact that you are including them in comps and it will have a fairly material effect on the comp comparison?

Betsy Burton

We really don’t break out those sales because we really don’t treat it as a separate division or a separate brand, so we really do not want to disclose those sales.

Jeff Stein - Keybanc Capital Markets

Looking at the Gordon's side of the business, long-term how do you -- you know, I can understand kind of combining the back-ends of the business, taking advantage of the purchasing power. That makes all the sense in the world but long term, how do you maximize the sale opportunity at Gordon's? Because it just seems to be that as long as I could remember, you’ve never really figured out how to position that business and how to maximize productivity, whereby they pretty much have the same real estate in the malls that Zale does but you don’t have the same visibility of the brand. Can you make this a -- or is there a possibility to make this a second national brand, and if so, how do you get there?

Betsy Burton

We’ve done an extensive analysis using ROGI, return on gross investment, to look at all of our brands. And in looking at the Gordon's brand, we believe that it is not -- it does not have the potential to be national in scale because there are stores that are not above the cost of capital and would result in our focusing more on our core markets.

Gordon's performs very well in several of its strongholds, so the key here would be over time as leases come up for renewal, we would focus on the markets that are performing quite well, even opening stores in those markets but closing stores in some of the unproductive markets or outlying markets.

Jeff Stein - Keybanc Capital Markets

And a question regarding Piercing Pagoda and Bailey Banks & Biddle. I mean, it sounds to me like your real opportunity to enhance shareholder value is to invest in the core mall businesses, but in recent years you’ve downsized Bailey, Piercing Pagoda has never really met its expectations, and I’m wondering -- are these assets that you guys would consider disposing of given the fact that you are taking a closer look at return on invested capital?

Betsy Burton

Yes, in fact, Jeff, we have gone through that analysis and for lots of reasons, I am really not at liberty to talk about where we are at specifically, but clearly that is something we’ve looked at. I have to say though, on Piercing Pagoda, it generates very nice cash flows and is a nice return on investment. So we are looking at more if it were a brand that wasn’t necessarily -- that was producing a very low return on investment, that that would be more of a candidate that would be for divestiture.

Rodney Carter

I think in addition what we’ve done is focused -- we’ve realized value from each of those brands but yet we’ve continued to focus on the growth and the comments on capital growth even this year are focused on the high return, the high returning brands and outlets and in Canada, so there is kind of a redirection of capital investment from a growth standpoint to those areas that are driving the highest returns while we optimize our returns on the other brands.

Jeff Stein - Keybanc Capital Markets

Got it, and final question, now that you mention Canada, Rodney, what really are the growth opportunities in Canada? Because it is a much smaller market. I mean, how much further can you take that concept in terms of rolling out stores?

Rodney Carter

We’ve got two brands up there. We’ve got People’s and Mappins. There’s a lot of opportunity for People’s but there’s even more opportunities for Mappins in that we don’t have a representation in much of the country. Realizing that it’s a much smaller market, we have a significant market share and presence and recognition there. It’s a great opportunity for some continued growth for some period of time.

Jeff Stein - Keybanc Capital Markets

Any thoughts in terms of how many potential Mappins stores you might be able to open over a five, 10-year period?

Rodney Carter

I think in the next five years, as many as we can physically do. I mean, there’s at least 100 or so.

Jeff Stein - Keybanc Capital Markets

Thank you.

Operator

Next we have Melissa Otto of W.R. Hambrecht.

Melissa Otto - W.R. Hambrecht

Good morning. Just a question on the outlet business. That channel has been consistently pretty strong for you guys. Could you give us a little bit more color on the differentiation strategy there? And I guess really how you are going to really stop the cannibalization I guess that’s been going on with your mall stores.

Betsy Burton

I’m not sure I understand the question about cannibalization of the mall stores, because the outlet stores are pretty much remote in terms of the malls. So clearly one of the nice things -- and I don’t want to talk too specifically because we do believe we have a better differentiated model, so let me talk a little bit about the difference in customer and it is clearly more of a female self-purchaser and a slightly more affluent customer, so there are some product differences in terms of assortment. But again, I don’t really want to talk too much about what we consider our competitive advantages.

Melissa Otto - W.R. Hambrecht

Okay, that’s all for me. Thank you.

Operator

Next we have Marc Bettinger from the Stanford Group.

Marc Bettinger - Stanford Group Company

Betsy, what kind of comp are you assuming for the second quarter?

Rodney Carter

Similar to what the annual guidance was.

Betsy Burton

Yes, it’s pretty much as we said, 1% to 2%.

Marc Bettinger - Stanford Group Company

Okay, and what kind of assumptions are you making about the consumer and bigger picture going into the season?

Betsy Burton

As we all are looking at the macro environment and we think that the moderate customer in particular has been impacted by the high cost of gas and the housing problems, et cetera. However, we believe that there’s some operational executional things we can do, so we are cautious about the environment but we are not overly concerned about the macro environment at this point.

We believe our plans are conservative and have taken into account the fact that it’s a challenging macro environment.

Marc Bettinger - Stanford Group Company

All right, so at 1% to 2%, do you assume that it worsens from here, or that it stays steady from here?

Betsy Burton

Pretty much stays steady from here.

Marc Bettinger - Stanford Group Company

Okay, and Rodney, the direct sourcing from 27% to 35%, what kind of boost is that giving you to the IMUs?

Rodney Carter

We’ve got somewhere in the neighborhood of 40 to 50 basis points of improvement.

Marc Bettinger - Stanford Group Company

Okay, and on the way to 50% would give you how much more?

Betsy Burton

Well, we’ve always said 50 basis points a year for the next three years, and we feel pretty comfortable with that and potential upside from there.

Marc Bettinger - Stanford Group Company

Okay, and the centralized merchandising that you have, what kind of savings are you looking for in ’08?

Betsy Burton

It is almost the same thing. In other words, the central -- let me just talk a little bit about the long-term strategy and as you can well imagine, holiday is sort of put to bed and so there really is not a lot of ability to impact until next holiday.

But what we are doing is we are really looking at centralized merchandising as the merchants really truly becoming merchants and focusing on product assortments and what the customer wants and needs as opposed to buying at the best cost.

The central sourcing organization, which will be led by Gil, will be focused on make sure we are buying at the best cost, so that is also potentially buying direct from factories, bringing it through ZAP, so again, that sourcing group would be the group that would also be -- would be the 50 basis points a year that we are talking about. So the cost savings will be driven by the sourcing organization, but again most of that will be driven by buying direct from factory or negotiating cost from vendors at the lowest price as if they were buying direct from factory.

So again, the strategy for vendors going forward will be very clearly transparency in terms of let’s buy at the very best cost and we are very focused on that going into ’08.

Marc Bettinger - Stanford Group Company

Okay, and last question -- as far as closest number to cash earnings, because obviously there were a lot of moving parts here, is the $1.52 for ’07 the best basis to use going forward?

Rodney Carter

Closer to $1.85.

Marc Bettinger - Stanford Group Company

The $1.85 to use? Okay, and to that, add 15%?

Rodney Carter

Yes.

Marc Bettinger - Stanford Group Company

Okay, great. Thank you very much and good luck.

Operator

Next we have a question from Bill Armstrong of C L King & Associates.

William Armstrong - C L King & Associates

Good morning. Most of my questions have been answered but Rodney, I think you gave earnings guidance for the first two quarters. I was wondering if you could flesh it out for Q3 and Q4.

Rodney Carter

No, I think we’ll look through the trends of holiday and have a much more robust look at what that path looks like. We’ve given as much guidance as I think we can give at this point.

William Armstrong - C L King & Associates

Okay.

Rodney Carter

They are just very small quarters out there, so --

William Armstrong - C L King & Associates

Right, I understand. Okay, second question, inventories will come down about $15 million over the course of fiscal ’08. Did I hear you say that you are also going to increase your accounts payable during that time?

Rodney Carter

Well, yes but not as a strategic difference. It’s just we didn’t replenish and so as we paid through, because we had built so much inventory, we did not have the normal benefit of is your normal cycle of merchandise payable, so it’s not a strategic stretch vendors or any of those types of things. It’s simply that we will be buying replenishment product and will have the natural credit benefit from a cash flow perspective.

William Armstrong - C L King & Associates

I see. Okay, and will those -- those will be the I guess the principal factors, or two of the major factors in the --

Rodney Carter

No, the other big one is the continued success of the warranty sales.

William Armstrong - C L King & Associates

Right, right. Okay. That’s all I had. Thanks.

Operator

And our next question comes from the line of David Mann of Johnson Rice.

David Mann - Johnson Rice

Thank you. Good morning. On the remaining clearance inventory that you have, can you just talk about the decision to try and continue to sell it through the store base rather than perhaps selling it out through a [jaw] burn and just monetizing it more quickly?

Rodney Carter

I think we are selling it at a good gross margin, at a good pace, so this is not damaged or tainted or past fashion products. That really does not make sense. If we can sell it at a good margin, granted we have a little bit of carry costs, but rather than incurring a significant markdown and we have to clear it through some of the other brands. The brands are more aligned and working on a more collaborative basis, there’s a much better ability to tap the collective throughput of all brands.

David Mann - Johnson Rice

In terms of the store portfolio, can you talk about the opportunity to perhaps move a little more aggressively with store closures that could accelerate the move towards I guess the store concepts that have the higher return?

Betsy Burton

We are looking at that but as you know, holiday is when we produce all of our cash and generate profit, so post-holiday, we will be looking at it and we have identified a group of stores that we believe there would be benefit to closing but we don’t want to quantify it at this time. Again, we’ll take one more look at it because if there’s an opportunity to -- if it looks like we can make some operational improvements to get it to its cost of capital to a level where it would make more sense to keep it open, we will.

The other thing that you have to recognize too is we need to work through it in a way in which we don’t get clogged with inventory if we close stores. So there are multiple considerations.

Rodney Carter

The way I’d look at it, and we’ve discussed it in the past, is we’ve added a much greater degree of rigor for many months, whether it’s new store investments or renewals. And this takes time to show up and from a return on capital standpoint and a real estate standpoint, but Betsy had talked about not viewing U.S. malls as a growth vehicle and that’s part of that backdrop. There’s a much more stringent focus on letting lapse modest performers that are below the cost of capital on renewing stores. Even on the new store growth is all really focused on the brands that are driving significant returns above the cost of capital, so it will take some time to show up but I think there is more movement in these decisions than you might see from the surface.

David Mann - Johnson Rice

And perhaps to prepare the investor base with what the opportunity might be, I know you don’t want to quantify specifically, but are we talking a couple percent of the base, are we talking 10%? How should we think about a range of possibilities there?

Rodney Carter

I think it will be a meaningful effort going through but again, on new and existing ones. As you know, we have quite a few leases that mature in coming years, whether they be kiosks or stores. This will be an ongoing part of the discipline so I’d rather not comment specifically at this point in time.

David Mann - Johnson Rice

Okay. Can you talk a little bit about the management structure change? I think a year ago, you were very excited about having a brand president; now you are going in a different direction. Can you just explain why that’s not necessarily the right structure or why it wasn’t perhaps the right personnel?

Betsy Burton

It’s really two separate issues, so it was specifically with regard to the change at the Z&A brand was a change that was made primarily because his focus and management style was really not consistent with the culture that we are trying to create, so separate and apart, that wasn’t the decision about how do we consolidate, why did we eliminate the position of brand president. It perhaps accelerated our timeframe in moving towards a centralized organization but it was always part of the plan again to streamline the organization, starting with the support functions for the moderate brand.

David Mann - Johnson Rice

And the comment you are making of the culture you are trying to create, how would you characterize that?

Betsy Burton

One of building a team as opposed to it used to be the brands sort of competed with each other, so really operating it as a corporate team, more collaboration and really empowerment of people, and really involving people, and a whole focus on the customer. I think we’ve got -- we’ve really done a lot of work with regard to what are the Zale Corporation values, customer being number one at the top, so returning to being a customer-centric company. Our people, number two, how do we invest in our people and how do we help them believe in themselves and believe in others, and really get the best results of our people, because our people are on the front line, whether it’s here at corporate or whether it’s in the stores with the customer. And then really focusing on building a culture here to support that.

David Mann - Johnson Rice

One last question, and this is a question that every investor asks me first, and I am sure every other analyst because given your approach by your major competitor a little over a year ago, I think most investors think a combination would make a lot of sense. Can you just sort of walk through why the investor base should be more patient with the strategy that you are putting forth, versus perhaps pursuing a combination?

Betsy Burton

It is something that everybody has asked, everybody says it makes a lot of sense. But really, it is far more structurally complicated than I think anybody fully understands, so it is not easy to accomplish. In other words, I think it is something that -- and clearly I don’t really want to get into the particulars but it is something that we have looked at, examined very closely, and do not feel that there is an easy way to structure something that would return value to our shareholders that would be sufficient for them to agree with it.

David Mann - Johnson Rice

Thank you very much.

Operator

At this time, I have no further questions.

Betsy Burton

Okay. Thank you all and let’s have a great 2008.

Operator

Thank you for participating in today’s call. You may now disconnect.

Copyright policy: All transcripts on this site are copyright Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

Source: Zale F4Q07 (Qtr End 7/31/07) Earnings Call Transcript
This Transcript
All Transcripts