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Zales Corporation (NYSE:ZLC)

F1Q08 Earnings Call

November 20, 2007 9:00 am ET

Executives

Betsy Burton - CEO

Rodney Carter - CFO

Cindy Gordon - Controller

David Sternblitz - Treasurer

Analysts

Brian Tunick - J. P. Morgan

Adrianne Shapira - Goldman Sachs & Company

Lorraine Maikis - Merrill Lynch

Connie Wong - Cowen and Company

Jeff Stein - Keybanc Capital Markets

William Armstrong - CL King & Associates

David Mann - Johnson Rice and Company

Marc Bettinger - Stanford Group Company

Patrick J. Forkin, III, CPA – Tejas Securities Group, Inc.

Rod Whitehead – Deutsche Securities

Janet Kloppenburg – JJK Research

[Farouk Ferkey] - Imperial Capital

Operator

I would like to welcome everyone to the Zales Corporation FirstQuarter Earnings Release Conference call. (Operator Instructions) I wouldknow like to turn the call over to Mrs. Betsy Burton, Chief ExecutiveOfficer. Mrs. Betsy Burton, you maybegin your conference.

Betsy Burton

Thank you. Goodmorning and thank you for joining us for our first quarter conferencecall. I am Betsy Burton, Chief ExecutiveOfficer of Zales Corporation. With me onthe call today are Rodney Carter, Chief Administrative and Chief FinancialOfficer, Cindy Gordon, Controller and David Sternblitz, Treasurer. Before we begin, Rodney will review the Safe Harbor.

Rodney Carter

Thank you Betsy. Our comments,responses and responses to your questions on this conference call will containcertain forward looking statements including statements related to our futuregoals, plans and objectives. Theseforward looking statements are not guarantees of future performance and avariety of factors could cause our actual results to differ materially from theanticipated or expected results expressed in these forward-lookingstatements.

Information concerning some of the factors that could causeactual results to differ materially from those contained in the forward-lookingstatements is available in our Annual Report on Form 10K for the year ended July 31, 2007 as filed with theSEC.

In addition, we may present information on this call thatwould be considered non-GAAP financial information. For a reconciliation for each non GAAPfinancial measure to the most directly comparable GAAP financial measure,please refer to the company’s most recent sales and earnings release which canbe found on our website www.ZalesCorp.comunder financial information and in news releases.

Betsy Burton

Thank you, Rodney. Q1results were in line with expectations. It should be noted that all numbers reflect results from continuingoperations. We did complete the sale ofBailey, Banks & Biddle earlier this month and this results are reported indiscontinued operations. The sale ofBaileys is consistent with our strategy to focus on the core business and toincrease returns on capitol. Therecently announced share repurchase is also a way to return value toshareholders. I would like to thank theentire team of associates at Bailey, Banks & Biddle for their hard work,dedication and commitment to building a great brand. Now, for the quarter.

Comps for sales decreased slightly .4% and the net loss forthe quarter from continuing operations was $0.54 per share, in line withguidance. Cash from warranty sales increased$9.5 million over the first quarter last year but, revenues recognized were$6.1 million less than last year as a result of the switch from a two year to alifetime jewelry protection plan. Thisresulted in an increase in unrecognized revenues for the first quarter of $14.3million, or $0.18 earnings per share. After adjusting for the incremental unrecognized cash sales, the netloss per share is $0.36 compared to a net loss of $0.43 last year, excludingthe loss from derivatives.

Here are some of the highlights for the quarter. Zales, Gordons and Pagoda comp stores salesdeclined in the low to mid single digits upset by continued strengthened outletup mid single digits, Peoples up double digits and .com with continued highdouble digit increases. We sawconsistent gross margin rate improvement across all brands when you adjust forthe warranty change. As we continue tofocus on maximizing gross margin dollars.

Actual merchandise margins were up 80 basis points comparedto last year. Merchandise gross marginpercent at the Zales brand was up 50 basis points, due primarily to the lowerclearance mix at a higher gross margin rate. Claires' was 11% of sales this year versus 20% last year. Gordons also experienced a 40 basis pointimprovement in gross margin rate which mostly offset negative comp sales. This is due largely to better coordination ofmarketing and promotional efforts with the Zales brand to mitigate cannibalization. Outlets’ strong performance continues withalmost all summaries having positive comps, particularly wedding and sales ofhigher carat weight goods. Merchandisegross margin improved 70 basis points due to strength in pricing and markdowncontrols. At Pagoda, while negativecomps track almost entirely to declines in mall traffic, margin dollars wereactually above plan and 180 basis points higher than last year. This can be attributed to a combination ofmix shift and retail price adjustments on gold chains and earnings.

Canadahad a very strong performance on all fronts. Almost every summary had a positive sales trend, also benefiting fromthe strong Canadian dollar. And, albeita higher Canadian dollar increased SG&A expenses in US dollars, sales morethan compensated due to an even greater benefit. Canadaalso experienced a very strong 220 basis point improvement in gross marginpercent due to an increase in direct sourcing and diamond fashion and thecontinued benefit from the repeal of the excise tax. We also made continued progress in Q1 inregards to our direct sourcing initiative. The percent of sales of goods from our loose diamond assembly operationincreased from 7.9% to 10.4% and total direct source goods grew from 33.2% ofsales last year to 35.5% this year with an improvement with direct sourcemargin of nearly 100 basis points.

Let me know give you a quick update on our various strategicinitiatives in progress to date. Thefirst component of our strategy is the focus on our core mall business. We have identified three key initiatives to driveimprovement. The first is a pilot tobuild a best in class customer experience which we believe can result insignificant growth in same store sales. First and foremost in the focus on the customer. Areas of emphasis include product knowledgetraining and training in consulted selling. Next, are changes in work flow to free up the associates time to spendwith the customer. Then, there areproduct assortment improvements, policy changes and tools to support andoverall improved experience. The test is currently live and on track for thepilot stores to deliver increased sales of a trend for holiday.

The second initiative is focused on increasing gross marginthrough continued growth in direct sourcing, refinements in pricing andimprovements in our supply chain strategy to drive cost savings. We also see an opportunity to improve storereturn by focusing on assortment optimization and gross margin return oninvestment in space and inventory. Thisincludes a shift in assortment mix toward core diamond summaries, decreasinginvestment and non-core summaries and a reduction in the gap in SKU countbetween high volume and low volume stores in the diamond wedding categories.

The third major initiative is a continued emphasis on areturn on capitol. This means putting asharp lens on all real estate decisions and evaluating store-by-storeperformance based on return on capitol. This focus applies to new and existing stores. We will close stores that are not meetingtheir cost of capitol and where it is unlikely operational improvement wouldget it even close to the hurdle. We willalso scale back investment in new stores for the Zales and Gordons brands untilwe have made progress in making operational improvements. Where we will investis in those brands and formats that produced the highest returns on capitol: Canada,outlets and .com.

Now, our immediate focus is clearly holiday. Last year we returned to dominate assortmentin diamond solitaries and diamond fashion. This year we will inject some newness into assortment but, an overalldiamond focus will continue. Diamondfashion is always key at holiday and this year, again, Journey will be the musthave item. We do have some nextgeneration Journey styles including a new proprietary branded collection atZales Past, Present, Forever. We alsoexpect new right hand ring styling to show good growth and big, really big,gold hoop earnings with or without diamonds are the new hot trend forfall. In Canada,trends to be slightly behind the USmarkets so, Journey, introduced just this past spring presents a bigopportunity for Canadathis fall.

The marketing campaign for Zales will also be consistentwith last year. We will build on TVcreative from last year that returned us to Zales, the Diamond Store andfeatured the Vanessa Carlton song AThousand Miles. The ads will remainin a blend of emotion and product. Theybegan airing November 5th so hopefully you’ve already seenthem. We continue to be aggressive inprimetime and highly visible TV spots. Our overall advertising spend should be relatively flat with lastyear.

We believe there is also an opportunity without pricing andbrilliant buy strategy. We plan tocontinue our key item strategy, just not as broad or deep in terms of discounting. This is consistent with our strategy for thepast several quarters of balancing top line growth with profitability. We expect these refinements and pricing toresult in increased gross margin dollars during the holiday season. We recognize that even with our opportunitiesin improved execution, it is against a back drop of a more challenging retailenvironment. So, given current trends weare forecasting comps of Q2 of flat to slightly negative and as we continue toexecute our strategy of maximizing gross margin dollars and maintaining goodexpense control we believe we can deliver bottom line results just slightlybelow current expectations. So, when youadjust for the sale of Bailey, Banks & Biddle, earnings from continueoperations are expected to be in the range of $1.60 to $1.65 per share.

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

Rodney Carter

As Betsy indicated our first quarter results reflect Bailey,Banks & Biddle as discontinued operations. The results of the brands’ performance have been isolated and reportedon separate line items that are not included in revenues or the traditionalincome statement for both October 31, 2007 and 2006 and balance sheet lineitems as of October 31, 2007.

The following are the key statistics for the first quarterof fiscal 2008. Comp store salesdecreased .4% for the quarter. Thestrongest performance continue to be turned in by our Peoples and outlet brand,as well as .com. The remaining brandshad low to mid single digit negative comp store sales. Total revenues were $377 million compared to$382 million last year; a decrease of 1.3% for the quarter. This reflects a $6.1 million decline inrecognized warranty revenues.

Gross margin for the quarter was 52.5% of sales versus 52.9%last year. The decrease reflects an 80basis point impact from the lower recognized revenues compared to last year dueto the change in the lifetime warranty product. Actually merchandise margins were up 80 basis points compared to lastyear which was consistent with our plan and our reduced emphasis on clearancecompared to the prior year.

Merchandise inventory as of October 31, 2007 was $1 Billionversus $1.2 Billion last year. Excludingthe impact of Bailey, Banks & Biddle, inventory was relatively flat. Inventory levels include approximately $17 milliondue to the exchange rate impact on the Canadian brands’ inventory. Inventory turn over on a rolling 12 monthbasis was slightly lower at 1.1 times this year versus 1.3 times lastyear.

SG&A including the cost of insurance operations was58.5% for the quarter versus 56% last year as a percentage of revenues. The increase from last year reflects 100basis points from the lower recognized revenues due to the change in thelifetime warranty product, 100 basis points from increased occupancy expensesand 50 basis points in consulting fees associated with the initiatives Betsymentioned.

The operating loss for the quarter was $37.5 millioncompared to $34.2 million last year which included the loss from derivatives of$8.6 million. The first quarter loss wasnegatively impacted by the change in amortized revenues associated with thechange in the warranty product. Theeffective tax rate for the quarter was 36.9% versus 37.3% last year. The net loss for the quarter from continuingoperations was $26.7 million or $0.54 per share versus a $24.7 million net lossor $0.51 per share last year.

During the holiday quarter last year we extended the serviceperiod for the warranty plan offered to our customers from two years to thelifetime of product ownership while simultaneously raising the retailprice. Well actual sales continued toincrease over the comparable prior year period, revenues recognized have beennegatively impacted. As we indicated inour 2007 Year End Earnings Call, we believe that the net change in unrecognizedrevenues will consistently provide insight into the incremental cash andpotential impact on future earnings. Wewill refer to this metric as cash warranty earnings per share. The increase in unrecognized revenues for thefirst quarter was $14.3 million or $0.18 per share. This compares to a decrease in unrecognizedrevenue of $1.3 million or $0.02 per share in the first quarter of lastyear. Including the impact ofunrecognized revenues the cash warranty loss is $0.36 per share compared to$0.43 last year, excluding the loss from derivatives.

During the quarter we opened 12 stores and four kiosks. We closed two stores and five kiosks. In addition, we will open 10 additionalstores prior to Thanksgiving. Weremodeled and refurbished 16 stores and four kiosks in the quarter. Excluding Bailey, Banks & Biddle, weended the quarter with 2,203 locations as follows: Zales 796, Gordons 282, Outlet 137, Peoples196 and Pagoda 792. The capitolexpenditure plan is approximately $100 million for the fiscal year for thetotal target of 37 new jewelry stores primarily in the outlet, Peoples andZales brand and 10 new Piercing Pagoda kiosks.

We ended the quarter with borrowing of $298 million underthe line of credit, or approximately $100 million lower than the prioryear. We had $30 million in cash atquarter end compared to $50 million last year.

I would now like to turn the focus to our earnings guidancefor the second quarter and the back half of the year in light of the impact ofthe sale of Bailey, Banks & Biddle. The Bailey, Banks & Biddle sale will allow the company to focus onthe opportunities in our core modern brands but, at the same time return valueto our shareholders in the form of a $200 million share repurchaseprogram. We plan to enter into a $100 millionaccelerated repurchase program and a 10B51 program which should allow us tocomplete over half of the authorized amount in the second quarter. We expect to complete the balance of the $200million authorization during the remainder of fiscal 2008. Given the timing, the full benefit in thereduction of shares outstanding will now be annualized in earnings per shareuntil fiscal 2009.

We are reducing our second quarter comparable store salesexpectations from up 1-2% to flat to slightly negative. This reduction reflects a cautious outlook onconsumer spending. As adjusted for the saleof Bailey, Banks & Biddle and our share repurchase program, our GAAPguidance from continuing operations in the second quarter is $1.60 -$1.65. This compares to approximateearnings from continuing operations of $1.57 last year. This reflects a $0.27 reduction in earningsfrom Bailey, Banks & Biddle due to the sale, the anticipated benefit of theshare repurchase plan of approximately $0.10 and a $0.10 reduction based on thecompany’s cautious outlook for the holiday season. Because of the positive impact of the sharerepurchase program that will be attained over the course of the fiscal year andthe earnings of Bailey, Banks & Biddle will be immediately deducted, thesale will be dilutive for fiscal 2008.

The estimated increase in unrecognized revenues for thesecond quarter is $38 million or approximately $0.50 per share compared to anincrease in unrecognized revenues last year of $30 million or $0.37 pershare. Including the impact of theincreased in unrecognized revenue cash warranty earnings per share are $2.10 to$2.15 this year compared to $1.80 last year excluding the impact ofderivatives.

Our original GAAP guidance for the year was $1.11 to $1.16adjusted for the anticipated $80-$90 million increase in unrecognized revenuesour cash warranty earnings per share would have been $2.11 to $2.16. A revised fiscal year GAAP guidance fromcontinuing operations which excludes Bailey, Banks & Biddle is $0.86 to$0.91 per diluted share. After addingback the same $80-90 million increase in unrecognized revenue, or a $1.00 offuture earnings, cash warranty earnings per share is now expected to be $1.86to $1.91. The revised guidance reflectsa $14 million reduction in earnings from continuing operations related toBailey, Banks & Biddle, our cautious outlook for the holiday quarter andthe benefit of an estimated repurchase over the next three quarters of eightplus million shares. On an annualizedcash warranty earnings per share basis, we expected transactions to be[inaudible].

Now, turning to forecasted free cash flow. Excluding the $175 million of net proceeds ofthe sale of Bailey, Banks & Biddle, we expect free operating cash flow inthe range of $100-125 million. Thedecrease from our original projections of $125-150 million is primarily theremoval of the free cash flow from Bailey, Banks & Biddle. So, again, we anticipate generatingsignificant free cash flow in fiscal 2008, thus providing significant financialflexibility to the company.

David and I will be available to discuss any furtherquestions after the call. We will nowopen up for questions.

Question-and-AnswerSession

Operator

Your first question comes from the line of Brian Tunick - J.P.Morgan.

Brian Tunick - J. P.Morgan

Good morning Betsey and Rodney and David. I guess my question first for Rodney is, Ithink previously you talked about 30% earnings growth, half from the warrantyrecognition and half from the core business. Is that still something you endorse off these lowered numbers? And then secondly, on the same thinkingthere, are there any expenses related to any of these in store improvementsfrom training to store payroll that you talked about today Betsey?

Betsy Burton

Okay, let me answer the first.

Rodney Carter

First of all, yes there is still, actually, some of thethird revenue will now be recognized over a lesser share base. So, the types of increase, the annualizedbenefit of 09 and 2010, those were the years we talked about the 30% or sogain, roughly half coming from the warranty recognition still is valid.

Betsy Burton

Brian, in terms of the costs of some of the improvements, inthe pilot stores there have been some costs and we’re in the process,obviously, of looking at where we get the biggest bang for the buck andreturn. So, post holiday will actuallybe refining it, looking at it and then, obviously, making a decision as towhich elements pay off and which ones don’t. But, relatively minor cost to date.

Brian Tunick - J. P.Morgan

Okay. Thanks. Good luck.

Betsy Burton

Sure. Thank you.

Operator

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

Adrianne Shapira -Goldman Sachs & Company

Thank you. Just a fewquestions, as you clear tempering the top line based on consumer spendingoutlook into the holiday season, does that impact at all the warrantyattachment rates? You had called outsort of a nice impressive step up to about 50%. Has that held steady? Any changeat all to those attachment rates?

Rodney Carter

We’re not see any change to the attachment rate.

Betsy Burton

Yeah, it’s strong. It’s still as strong.

Adrianne Shapira -Goldman Sachs & Company

Okay. So, it’smaintained around that 50% level?

Betsy Burton

Correct.

Adrianne Shapira -Goldman Sachs & Company

Okay. Then, as far asyou talked about the sharpening of the lens in terms of return on capitol. Any sense, can you give us in terms of storeclosures, or what sort of capitol you might be paring back as you scale backthose investments? If you can sort ofgive us any type of range? You hadalluded to it last quarter as well.

Betsy Burton

Yes. The range thatwe eluded to last quarter, and a lot of this is normal course. In other words, these are stores that we arejust simply not renewing. So, it’s nota, “Buy now [inaudible] a big charge.” It is just simply not renewing. So, we had mentioned in the range of 30-40 stores. But again, we will look at this post holidayand the important thing to note too is that with some of the operationalimprovements that we’ve seen to date in our pilot stores we also need to goback and make sure that we would make the same decision based off if we were tooverlay the operational improvements.

Adrianne Shapira -Goldman Sachs & Company

Great. That’shelpful. Thanks. Then, as far as, you know, obviously we wereseeing commodities pricing increasing, obviously we’ve all seen what hashappened to gold prices. Can you talkabout what decisions are being made, how much of those increases are youpassing through? How much is theconsumer accepting? How much of thedirect sourcing benefit should we expect to continue given how gold prices haveescalated?

Betsy Burton

Okay. We have taken alot of the price increases in the Pagoda brand in particular which is heavilydependant upon the commodity gold. Interms of the Zales brand and the Gordons brand, we did go out and we did amajor competitive check and we found opportunities to raise our prices and insome instances we were not able to. So,it has been mixed but, you know, clearly we also need to be competitive. The bigger opportunity though also as webecome less aggressive in terms of our brilliant buy pricing which is typicallyanywhere from 20-25% of our total mix.

Adrianne Shapira -Goldman Sachs & Company

Okay. That was justmy last question. If you were to help usunderstand the year-over-year reduction in the brilliant but program, give us asense what that represents this year, what it represented last year and perhapsreconcile that as you are expecting clearly a tougher holiday outlook. Talk about the decisions to kind of rein inthose promotional prices. Thanks.

Betsy Burton

Sure. Our promotionalprices, our brilliant buys this year will be approximately – are projected at25% of our total mix. Last year it was36% of our total mix and we project a 400 basis point improvement of grossmargin in those brilliant buys. In termsof the back drop of the macro environment, clearly we believe this is a year inwhich we don’t chase sales. We believewe are competitively priced so we still have – last year we may have had 1,000brilliant buys and this year we may have 700-800 key items. So, we have not cut back so significantlythat we believe it will impact our sales. But, we also believe we have an opportunity to capture growth margin andto maximize gross margin dollars this year.

Adrianne Shapira -Goldman Sachs & Company

Thank you.

Betsy Burton

Thank you.

Operator

Your next question comes from line of Lorraine Maikis ofMerrill Lynch. Lorraineyour line is open.

Lorraine Maikis - Merrill Lynch

Hello?

Operator

Go ahead.

Betsy Burton

Hi Lorraine.

Lorraine Maikis - Merrill Lynch

Hi. Goodmorning. Can you give us a quick updateon your inventory goals for the year? Iknow you had spoken about bringing that balance down by about $50 million andthen also just update us on how much old clearance merchandise is still onbalance sheet.

Betsy Burton

Okay, let me talk first about the old clearancemerchandise. We’re down to about $19 million. This time last year we had $68 million downfrom the starting point at $85 million. So, we’ve worked through the clearance pretty successfully. And, clearance will always be about 10% ofour total inventory. There is ongoingclearance as you bring in fresh goods. In terms of our overall inventory goals we are working throughthat. As I alluded to in one of theinitiatives that our consultants are working on, we believe there may be amajor SKU rationalization in some of the non-core categories. We need to come up with sort of a total planfor the inventory clean up. In additionto that, as I think I alluded to also, we are going to refocus on some of thecore bridal and diamond categories. Notthat we believe there will be a build in dollars, it will be simply a shiftingof dollars. And so again, we’re not atthis point ready to say that the $50 million is a real number. You also need to know that $10 million ofthat plan reduction would have been in the Bailey, Banks & Biddle brand sothat will go away, that benefit.

Lorraine Maikis - Merrill Lynch

Your reversing course on the initiative you talked aboutearlier in the year about bringing the inventory balance down?

Betsy Burton

No, not really. Whatwe had talked about was bringing down the excess which we have worked throughin terms of the, as you know, with the Zales brand we brought in $120 millionof inventory last year. You know clearlywe had to work through about $50 million of excess inventory. But, it was good product going [inaudible]program and merchandise. We have workedthrough that however, we have also had to investment spend in some of the corecategories identified in terms of this assortment optimization and we’veinvestment spent in the Pagoda brand, as well as a little in the outletbrand. And then, $15 million or $17 millionis due to growth I guess, is due to the Canadian exchange rate. So, that’s not real growth in inventory so,that would have been reduced had we been on a level playing field. Is that clear?

Lorraine Maikis - Merrill Lynch

Yes, that’s clearer. Can you just talk a little bit about SG&A as well? Do you have any initiative, I know you talkedabout some in store initiatives that sound like they’ll cost some money, isthere anything you can cut at this point given the expected weakness in yourtop line going forward?

Betsy Burton

Let’s focus on holidays. For Q2 we are clearly going back and store by store building payrollwhich is by far your single largest line item. Looking at stores which have much more negative trends and cutting backthere. We have looked at some potentialsaves in marketing but, at this point there are really no substantial cuts interms of the corporate SG&A and the reason for that is we believe over timethere will be efficiencies to be gained in terms of some of the centralizationstreamline of the merchandising organization operations. However, because of the magnitude of thepotential upside to grow same store sales and the opportunity in terms of grossmargins we felt that those have the opportunity to provide the most value,create the most value for shareholders that it focusing on cutting SG&Awould potentially impair our ability to have those initiatives be successful.

Lorraine Maikis - Merrill Lynch

Thank you.

Betsy Burton

Okay, thank you.

Operator

Your next question comes from the line of Connie Wong ofCowen and Company.

Connie Wong - Cowenand Company

Good morning. Thankyou for taking my question. Rodney,first question, given the accelerated $100 million in repurchase program andthe 10B51 plan, is it safe to assume about a 43 million share range for the endof second quarter? Or, do you expect itto be even lower than that given, you know, you guys have an outstandingprogram of $200 million?

Rodney Carter

I think on an average basis it can be 46 or a little bit northof that because, the two programs combined are, we have chosen to limit themboth within 10B18 limits. You know,there’s going to be somewhere between 100-120 million shares purchased and,again, the ASR as we mentioned in the press release can go as long as four anda half months depending upon trading volume. We’re targeting something in the 46-47 million share count as of Q2 foran average.

Connie Wong - Cowenand Company

As of Q2. Okay,great. Then, Betsy we’ve obviously seensome success in your online business. What are you anticipating for holiday? Do you expect your online sales penetration to increase? And, how are you positioning the onlinebusiness for holiday? Anything differentfrom what we should see in stores in relation to promotions?

Betsy Burton

We’re very optimistic, our online business is growing verynicely and we see that trend continuing. So, for the most part, the online will support all the promotions thatwe have going on in the brand. So, trulywe’re trying to capture the multi channel customer and have the customer thatshops online also come in store. But, weare not having, for instance, special Internet only promotions. They will all be multi channelpromotions.

Connie Wong - Cowenand Company

Okay, great. And thenlastly, are you seeing any regional difference in your sales given some costs,other retailers have mentioned given the macro environment in Californiaand Florida?

Betsy Burton

We are experiencing the same macro trend, in particular, in Florida,that is correct.

Connie Wong - Cowenand Company

Okay, great. Thankyou.

Betsy Burton

Thank you.

Operator

Your next question comes from the line of Jeff Stein ofKeybanc Capital Market.

Jeff Stein - KeybancCapital Markets

Good morning. I waswondering if you could talk about the number of stores that you have in thispilot test and how long they’ve been out there and what the performance hasbeen to date?

Betsy Burton

The initiative is very, very early and for competitivereasons we aren’t going to identify where these are but, there are 24 stores inthe initial pilot group and we’ve started, literally within the last weekstarted another group of stores where we took what we think were the two mostpromising elements of the pilot and sort of cut out all the other stuff and arelooking to run a sort of different variation of the original pilot. The results again, are too early to know but,right now are showing a very strong improvement versus their trends prior.

Jeff Stein - KeybancCapital Markets

Okay. And Betsy, withregard to the incremental costs, and I’m not sure if the prior questionrelating to incremental cost was in conjunction with the pilot aspect but, whatkind of an increase do you think you need to offset the higher training costs,or sustained increased costs of these pilot stores?

Betsy Burton

If the trend that we’re experiencing holds it is more thanself funding. And again, we’re lookingat paring back some of the elements that would reduce some of the costs as well.

Jeff Stein - KeybancCapital Markets

Okay. And, if we lookat the change in the guidance for the full year going to this $0.86 - $0.91range, if we kind of delayer it and just look at the portion that you’re takingout of the guidance that relates to a more conservative holiday outlook, mymath says it is about $6-7 million dollars after tax and I’m wondering ifthat’s a good guesstimate?

Betsy Burton

I think $0.09 to $0.10 EPS is what we had come up with justthe reduction and, you know, a couple of percentage points in comps. So, the math gets real murky because againthe share repurchase and obviously, the cash warranty add back.

Jeff Stein - KeybancCapital Markets

Okay. Yeah, I come upwith about $0.12 but, I guess that’s close enough. With regard to, can you give us some newinterest expense and B&A numbers for the balance of the year? It looks like Bailey had about $5.3 millionon an annualized basis so, we should deduct that and prorate it per quarter

Rodney Carter

I’m trying to look right now. Interest forecast is around $11 million, I’msorry, yeah, about $11 million for the full year.

Jeff Stein - KeybancCapital Markets

Okay. And B&A?

Rodney Carter

B&A is approximately $63 million.

David Mann - JohnsonRice and Company

$63-64 million.

Jeff Stein - KeybancCapital Markets

Thanks.

Betsy Burton

Thank you.

Operator

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

William Armstrong -CL King & Associates

Good morning. Just toget clear on the share buy backs, over the next three months we should see 4.3 millionplus 1.2 million bought back?

Rodney Carter

The 4.3 will come out immediately because of the equitytreatment of the ASR. The other dependson the trading volume at the timing but, that would be kind of the goal, Bill.

William Armstrong -CL King & Associates

Okay. Then, theremainder just comes as you go through your open market purchase?

Rodney Carter

Correct. We’ll getback into broader periods of open market because, we’ll have open windows totrade. Obviously, we’re going into anextended blackout period and we thought the ASR would give us a meaningfulimpact of share count up front and then take advantage of the volume differenceon a 10B51 to again, accelerate some of the benefits in a bigger quarter.

William Armstrong -CL King & Associates

Got it. So, the waythat works is that J. P. Morgan delivers the shares to you tomorrow and thenthey will go into the open market and buy shares to make that whole?

Rodney Carter

Correct.

William Armstrong -CL King & Associates

Okay. So, then theguidance, the $0.86 - $0.91 does that include the impact of the lower sharecount? Or, is that before the share buyback?

Rodney Carter

It includes it.

William Armstrong -CL King & Associates

That includes it? So,what would be the.

Rodney Carter

But, it’s not annualized though, Bill. It just kind of gives you the timing and thestep in. So, on average we’ll drop sharecount by a few million and then through the remainder of the year we’ll getabout 8 million out for next year.

William Armstrong -CL King & Associates

I understand. And sothen, the $0.86 - $0.91 what would be the, I guess denominator, or the averageshare count for the full year for that $0.86 - $0.91?

Rodney Carter

It’s about $0.455.

William Armstrong -CL King & Associates

Okay. Then, finally,just on the gross margins for the quarter, Rodney I think you were sayingthat you had an 80 basis point negativeimpact in deferred revenues, 80 basis points positive from merchandise margins,the overall gross margin was down about 50 basis points. I was wondering if you could just fill in theremainder above [inaudible] there?

Rodney Carter

The very minor amount as far as there is roughly about – ifyou need out Bailey’s last year would have been about 52.9 so there is about 40net basis points down. Warranty wasabout 80 basis points and then basically just some timing of when we took intrade in merchandise, just timing going in and out of some of the zapmerchandise and whatever else. So,basically it’s just 40 basis points of movement within the inventorycategories.

William Armstrong -CL King & Associates

Okay. Then I guess,finally underline the lower guidance for the full year of about $0.25. How much of that decline would be just fromBailey, Banks & Biddle alone?

Rodney Carter

About $0.20.

William Armstrong -CL King & Associates

$0.20? Okay. And then, the remainder would be from, likeyou mentioned before, just a lower expected same store sales number?

Rodney Carter

That and the fact that we don’t annualize the shares and wego into two quarters were we have some losses.

Betsy Burton

In other words, you take all of the earnings away fromBaileys but, you don’t get the full benefit in terms of share repurchase.

Rodney Carter

Right.

William Armstrong -CL King & Associates

Right, right. Okay. Any offsets, positiveoffsets to that? So, from maybe a betterthan expected gross margins? Or, notnecessarily?

Betsy Burton

I think we feel that these are pretty realistic.

William Armstrong -CL King & Associates

Okay. Okay. Thankyou.

Betsy Burton

Thank you.

Operator

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

David Mann - JohnsonRice and Company

Yes, thank you. Goodmorning. Rodney, can you talk a littlebit about what you’re seeing on the credit side in terms of approval rates andpenetration and just credit quality in general?

Rodney Carter

Right now approval rates are still continuing to climb. I think we had not emphasized credit to ourdetriment over time in the portfolio we have and again, the risk is born byCitigroup but, there’s not been any constraint. We’re not seeing anything other than a slight improvement in approvalrates. The standards are, theunderwriting standards are the same. So,it’s obviously something we want to watch given the macro background but, it’snot something that’s creating problems for us today.

David Mann - JohnsonRice and Company

And, regionally are you seeing that as well? Or, should we assume the macro trends aresort of [inaudible].

Rodney Carter

It’s really not that different.

David Mann - JohnsonRice and Company

Okay.

Then, can you just give us a sense on what the currencyimpact is on the P&L?

Rodney Carter

Currency impact is less than a half a cent.

Betsy Burton

It’s $300,000.

Rodney Carter

Less than a half a penny.

David Mann - JohnsonRice and Company

Okay. Then, in thesecond quarter should we see that jump at all?

Rodney Carter

Second quarter I think it will jump noticeable because thevolume difference is significantly greater.

Betsy Burton

It is in the numbers though. It’s planned.

Rodney Carter

Yep.

David Mann - JohnsonRice and Company

Okay. Thank you verymuch.

Betsy Burton

Thank you.

Operator

Your next question comes from Marc Bettinger of StanfordGroup.

Marc Bettinger -Stanford Group Company

Good morning everyone. Just real quickly, most of the questions have been answered, the merchandisemargin of 80 basis points, how much of that, I guess was less clearance asopposed to holding wholesale?

Betsy Burton

I’d say probably half because the Zale brand is such asignificant part, the Zale brand because of the magnitude but, the rest is truegrowth in terms of the direct sourcing efforts.

Marc Bettinger -Stanford Group Company

Okay. Thank you and good luck.

Operator

Your next question comes from Patrick Forkin of TejasSecurities.

Patrick J. Forkin,III, CPA – Tejas Securities Group, Inc.

Good morning. Withrespect to your private label credit program, are there any changes in the lineup for, you know, as far as the promotions you’re running? And, I was wondering if you could comment onaverage transaction size for private label versus other means of payment?

Rodney Carter

Average transaction size for private label is materiallyhigher than on average because you’ve got less gift giving, it tends to be moreof a bridal SKU. But, there haven’t beenany significant changes in those trends.

Patrick J. Forkin,III, CPA – Tejas Securities Group, Inc.

Okay.

Rodney Carter

It’s probably about three times average ticket on a privatelabel card.

Patrick J. Forkin,III, CPA – Tejas Securities Group, Inc.

Okay

Betsy Burton

And, the holiday mailer that is in the mail, we areintroducing, new to this year a six month same as cash no payment, no interest,no down which is new to this year.

Patrick J. Forkin,III, CPA – Tejas Securities Group, Inc.

Okay. And then, youmentioned in the past there hasn’t been really the level of emphasis on that instore credit that there should be. Myrecollection is that about 40% of your volume is on the private labelcard. Where do you want to be with thatprogram?

Rodney Carter

It’s slightly above 30%, I think before that we’ve probablygot eight to 10 percentage points higher mix. We have reemphasized the training and making people aware of thebenefits and so, I think we’ll see – the steady decline has plateau or flooredout and then we’ve regain some momentum in some of the brands at a modest level.

Betsy Burton

We actually see there’s an opportunity and we have recentlyput out some new materials, in terms of training materials because, we actuallydo have a stronger competitive offering than our major competitors. So, we think we have up side on that.

Patrick J. Forkin,III, CPA – Tejas Securities Group, Inc.

Are you talking about your major competitor, you know, inmall?

Betsy Burton

Correct.

Patrick J. Forkin,III, CPA – Tejas Securities Group, Inc.

Okay. Thank you.

Betsy Burton

Thank you.

Operator

Your next question comes from the line of Rod Whitehead ofDeutsche Bank.

Rod Whitehead –Deutsche Securities

Hi there. Just threequick questions if I may. Firstly, youmentioned a 400 basis points improvement in brilliant buy. Are you saying that the 25% of sales thatwill be brilliant buy, those items would have a 400 bit improvement versus lastyear? Secondly, do you have any forwardcover on your gold purchases as of now? Looking ahead to next year really. And, thirdly, your guidance on comps is no change in trend versus thelast six months of comps of the group. Does that reflect of you that there will be no deterioration in the year’sconsumer environment?

Betsy Burton

Okay. Let’s startwith the first one, that’s easy. Yes,you are absolutely correct, the 400 basis point improvement over last year interms of margins is real. So, in otherwords it will be brilliant buys will go from 36% down to 25% of the mix at a400 basis point improvement in margin. In terms of we do not have hedged, we have not hedged but, we havebought and locked into our gold prices through holiday and have pricedaccordingly. Then, we also see anopportunity with some of the what I call skew rationalization and in some ofthe metal categories that potentially we have an opportunity to melt and evenmake a slight profit and then, obviously, repurpose the gold. In terms of comps, the nice thing abouthaving sort of I call it diversified portfolio of brands is that even though USmall traffic is down and those brands have been hurt the most, we also havenice sales comp in outlets and Canada are driving helping offset some of thedeterioration. So, the comps that we areprojecting we feel pretty comfortable about.

Rodney Carter

We I only did adjust the guidance downwards to reflect this trend.

Betsy Burton

Yes. Did that answeryour question?

Rod Whitehead –Deutsche Securities

Yes. Just to becompletely clear on the brilliant buy, you’re not saying that it is thereduction from 36% to 25% that gives you 400 basis points?

Betsy Burton

No, it’s both. Yeah,no. It’s the reduction as a percent ofthe total and it’s an actual improvement in margin as well on that.

Rod Whitehead –Deutsche Securities

The two combined give you 400 basis points?

Rodney Carter

Correct.

Rod Whitehead –Deutsche Securities

Impact on the overall gross margin but then, there’s otherthings going the other way. You’re notguiding to 400 basis points on the [inaudible] gross margin, obviously?

Betsy Burton

Correct.

Rod Whitehead –Deutsche Securities

Okay, lovely. Thankyou very much.

Betsy Burton

Thank you.

Operator

You’re next question comes from the line of JanetKloppenburg, JJK Research.

Janet Kloppenburg –JJK Research

Good morning. I’m alittle bit confused on the second quarter outlook, Rodney. I know that there’s a $0.27 loss from, notloss but discontinued operation Bailey, Banks & Biddle. So, are you then saying that your outlook onthe second quarter is the same as it would have been, as is it had been exceptfor the Bailey, Banks & Biddle earnings? Is that correct?

Betsy Burton

No. There was this$0.09 to $0.10 reduction as a result of lowering our comps from up 1-2 to flatto slightly negative. So, there was a$0.09 to $0.10 impact.

Rodney Carter

But, there’s also a very similar amount based on a reductionin share count from the ASR.

Janet Kloppenburg –JJK Research

Right That’s what I’masking. Excuse me Betsey, I’m sorry butis it a complete offset is what I’m asking you guys?

Rodney Carter

Pretty close.

Janet Kloppenburg –JJK Research

It is pretty close. Okay. Did you reveal what yourestimate was for the Zales and Gordons comps to be? Or, the UScomps to be [inaudible] outlets?

Betsy Burton

No, we do not give comps by brand.

Janet Kloppenburg –JJK Research

Okay. But, I assumethat there’s a more conservative outlook for those brands given theirperformance in the first quarter? Isthat fair, Betsey?

Betsy Burton

That is correct and that is what we’re basing our guidanceoff of is actual trends.

Janet Kloppenburg –JJK Research

Okay. And, do youthink that is related to a macro trend? Or, do you think that is something fundamental to those brands?

Betsy Burton

I clearly believe that it is macro. I think if you talk to vendors, we aretracking actually, slightly better than some of our competition. But, clearly mall traffic is down anywherefrom 4-6% is what I hear. So, I think clearly,this will be a challenging macro environment, in particular, for malljewelry. But again, we believe that wehave opportunity because of some of the executional issues last year. But, clearly we are feeling the sametrend. You know, the Middle Americancustomer has been hit hard by whether it is the housing market bubble, whether it’sbeing overextended in credit in general, the high cost of gas, all of that ishitting our core customer which, you know, let’s say income in the $50-$100,000range. So, clearly it’s a phenomenonthat is affecting all retailers that have, especially have purchases that are discretionary. Then, on top of that you’re fighting fordollars with the iPod and flat screen TVs.

Janet Kloppenburg –JJK Research

Right. And, theGPS. The question I have is on theinventory. What about have you plannedthe inventory for Zales and Gordons in accordance with this change in compoutlook?

Betsy Burton

If you take out investment spend where, again, some of thework that our consultants are doing with regard to skew rationalization andincreasing certain parts of our assortment. If you take that out, we have clearly reduced our what we call thatexcess inventory and are working through it in terms of replenished goods.

Janet Kloppenburg –JJK Research

So, you think that if Zales and Gordons come in on theirrevised plans for the holiday season, then you’re inventory levels should bewhere you want them to be coming out of the quarter?

Betsy Burton

Yes.

Janet Kloppenburg – JJKResearch

Okay. I just waswondering if there was any sort of rethinking going on about pricing given howtough it is out there? And, if you hadany opportunity to maybe become sharper in pricing as the quarter went along?

Betsy Burton

We actually believe we have a very competitive promotionalcalendar. We are anniversarying all theevents and all the promotions we had last year. So, at this point, again, we’re looking at gross margin dollars,maximizing gross margin dollars and, you know, we believe our strategy is asound strategy.

Janet Kloppenburg –JJK Research

Okay. Just lastly,Rodney on the year, I think you said that because of the fact that you’ve beenusing an average share count as opposed to an absolute share count, you maybelose a nickel off your previous annual guidance. Is that a fair summation?

Rodney Carter

It’s closer to $0.10.

Janet Kloppenburg –JJK Research

It’s closer to $0.10 because of that?

Rodney Carter

Yes.

Janet Kloppenburg –JJK Research

Okay. Thanks verymuch and good luck for a great holiday.

Betsy Burton

Thank you.

Operator

Again, if you would like to ask a question simply pressstart and then the number one on your telephone key pad. Your next question comes from Farouk FerkeyImperial Capital.

Farouk FerkeyImperial Capital

Ah, good morning. Ijust have one question, are you able to buy your shares today? Right now?

Rodney Carter

No, the program won’t go in to effect tomorrow after theearnings release takes place.

Farouk FerkeyImperial Capital

Thank you.

Operator

There are no further questions at this time.

Betsy Burton

Okay, thank you Operator and thank you all for yourparticipation.

Operator

Thank you for participating in today’s Zales Corporationconference call. This call will beavailable for replay beginning at 11:00 AM Eastern time today through 11:59 PMEastern time on Tuesday, November 27, 2007. The conference ID number for the replay is 24763737. The number to dial in for the replay is706-645-9291. Thank you.

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