Zale F2Q06 (Qtr Ending Jan 31, 2006) Earnings Conference Call Transcript (ZLC)

Zale Q2 2006 Earnings Conference Call (ZLC)

February 17, 2006

Executives:

Betsy Burton, Chief Executive Officer
Sue Gove, Chief Operating Officer
Mark Lenz, Chief Financial Officer,
David Sternblitz, Treasurer.

Analysts:

Lauren Levitan, Cowen
Adrian Shapiro, Goldman Sachs
Jeff Stein, Key Bank Capital Market
Mark Freidman, Merrill Lynch
Mark Bedinger, Stanford Group
Bill Armstrong, CL King and Associates
Dax Lassus, Gates Capital Management
Robin Merchanson, Sun Trust
Harry Eichenson, Noland Berger Capital
Brian Tunic, JP Morgan
Jason Asada, Standard & Poors Equity

Presentation:

Betsy Burton, Chief Executive Officer

Good morning and thank you for joining us for our second quarter conference call. I am Betsy Burton, interim Chief Executive Officer, with me on the call today is Sue Gove, our Chief Operating Officer, Mark Lenz, our Chief Financial Officer, and David Sternblitz, our Treasurer. Before we begin, Mark will review the Safe Harbor.

Mark Lenz, Chief Financial Officer

Thanks Betsy. Our commentary and responses to your questions on this conference call will contain forward looking statements including statements related to our expected sales and earnings, 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 statement is available in our Annual Report on Form 10K for the year ended July 31, 2005 and our Quarterly Report on Form 10Q for the quarter ended October 31, 2005 as filed with the SEC.

In addition, we may present financial information on this call which would be considered non-GAAP financial information. Our reconciliation of each non-GAAP financial measures. For the most directly comparable GAAP financial measure, please refer to our Second Quarter Fiscal 2006 Earnings Release dated February 17, 2006 which can be found on our corporate website, www.Zalecorp.com under Shareholder Information and then News Releases.

Betsy Burton

Thank you, Mark. As you probably know, I’ve served on the Board of Directors of Zale for three years and I’ve been working in my new role as interim CEO since January 30th. Over the past few weeks, I have spent sine intensive time with the brands and key members of management. This morning I would like to start by giving you my insights on where we’re at and what needs to get done.

Let’s start with the decision to make a change in the CEO. Directionally, the Board was satisfied with where the business was headed but was disappointed that the progress at this point had not translated to better financial performance. There have been a number of quarterly earnings misses, a number of internal financial targets missed, and our largest brand, Zales saw its market share continue to erode. The Board felt it needed to be more focused on getting sort term traction in addition to building for the long-term.

As indicated in our Press Release, we have engaged an executive search firm to conduct the search with both internal and external candidates for the CEO position. In the meantime, I can assure you I am quite actively engaged in the business. The key focus is on Turing around the Zales brand. Upon review of the Zales’ business, we concluded that the new strategy negatively impacted our brand position because it deemphasized the value component of our offerings as well as key diamond categories in our assortment. Plus, in addition to the change in the CEO, we have also made a change with regard to the Zales brand. Effective the close of the day yesterday, we named Jonathan Zimmerman, currently President of Zales Canada to the newly created position of Zale North America John will now have responsibility for much of the pricing and store operations for Zales Jewelers, Peoples Jewelers and Mappins Jewelers. Paul Leonard, currently President of Zales has resigned. John and the management team will start immediately with an in-depth review to assess the strategy for the Zales brand going forward. We changed a lot of things in a very sort period of time. Some things worked, some things didn’t. We will learn from these findings and make adjustments accordingly. And just as important, we will make sure we do so in a manner not disruptive to the business.

Now, here’s what we learned from Holiday with the Zales brand. We walked away from promotion events in November and December to the tune of $22 million or the equivalent of a 6% comp. We had less emphasis on brilliant buys and key item promotions, which negatively impacted volume. We were short of inventory in critical categories such as diamond fashion and solitaires. And, a planned increase in gold and silver did not offset the decline in these core assortments. We were light on the above $799 product, which result in an average ticket decline of 7%. We shifted from TV from November to December and spent too much time on the back end running 15 second item priced spots. We ran new thematic spots, ascur and packages as part of a brand building strategy which was a departure from prior campaigns. We changed the tag line from the diamond store to be brilliant, now all of our marketing and advertising campaign announcements will be evaluated as to its effectiveness. Net, net we will examine all aspects of the Zale brand, the product, pricing, in-store experience and marketing for its strength, weaknesses, opportunities and threats. And we will take quick action to make changes as needed.

Now briefly, let’s go back to the other brands. Piercing Pagoda suffered due to a significant decline in the Italian charm category. Combined for the quarter, the sales in Pagoda experienced a 3% decline in comp. However, four brands, Gordon’s, Zales Outlet, Bailey Banks & Biddle and Peoples Jeweler, actually all had strong mid-single digit comp store increases. This resulted in an overall comp increase of 1.4% for the quarter. And, we had 100 basis point improvement in gross margins, excluding the impact of the Bailey Banks & Biddle store closures due to continued adoption of direct forcing and supply chain management.

So, in our critical quarter, we did deliver strong cash flow which enabled us to complete our $100 million share of re-purchase. As we move into the third quarter, we remain cautious, given the changes of sales and the time still needed to improve assortments and execution. Valentine’s Day had a slightly positive low single digit comp increase and we are thereby changing our guidance for the quarter to flat to slightly positive comps with EPS forecast in the range or 20¢ -- 24¢. We will not issue guidance for Q4 until we report Q3 results.

To summarize, we still have a lot of work to do, but our execution will get better and we are cautiously optimistic regarding the actions we have taken to date. We will eliminate distractions, focusing on those initiatives that will have the greatest impact on the business. We will stay disciplined, keeping the expense structure line and continue to deliver solid cash flow. We appreciate your patience through this process.

I would like to now turn the call over to Mark Lenz who will review the financials.

Mark Lenz

Thank you. The following are the key specifics for the second quarter of fiscal 2006. My comments later regarding the on-going business will exclude the impact of the Bailey Banks & Biddle stores identified for closure as part of our strategy to improve brand performance and profitability. The Company closed 32 Bailey Banks & Biddle stores during the quarter, 29 that were managed by a third party liquidator.

Second quarter results in the Income Statement accompanying the Press Release were affected by these closures as follows:

Total Revenue includes $15.1 million of sales in the 29 closed stores operated by the third party liquidator. Gross Margin includes $6.2 million worth of charges related to the disposition of inventory in the 29 stores, reducing the gross margin rate by 140 basis points, SG&A includes $18 million of expenses including charges for lease settlement and store absent impairment including $700,000 for the other stores not managed by the liquidator, increasing the SG&A rate by 130 basis points for the quarter. So in total, operating earnings for the quarter include charges of $24.2 million related to the store closing. On a year to date basis, SG&A includes approximately $26.4 million before taxes of expenses related to the store closing which includes the amounts identified in the second quarter above and a charge of approximately $8.4 million before taxes in the first quarter resulting from the impairment of fixed assets of the stores identified to be closed.

In total, the Company incurred approximately $15 million after taxes or 30¢ per share the second quarter and $20.2 million after taxes or 41¢ for the year to date period related to charges incurred for the closing stores. Increase from previous estimates of $15-16 million after taxes or 30¢ - 32¢ per share relates primarily to higher lease settlement expenses than originally estimated. While this represents the significant charge to the Company, we believe the store closing position the brand to focus on more profitable stores and long-term brand performance.

Now I’d like to discuss our on-going operations excluding the closed Bailey Banks & Biddle stores. As Betsy said comp store sales increased 1.4% for the quarter. Total revenues increased 2.8% for the quarter and 2.3% for the year to date. The impact of square footage and other growth to second quarter revenues was an increase of approximately 1.4%. The average transaction for the quarter by brand was as follows: Zales this year, $338, last year $36; Gordon’s $394 this year, $381 last year; Bailey Banks & Biddle on-going stores $1,559 this year, $1,405 last year; Zales Outlet $380 this year, $351 last year; Peoples in Canadian dollars $286 this year, $266 last year; and Piercing Pagoda, $41 this year, $39 last year.

As Betsy commented, the decrease in Zales average transaction now would lead to a lower mix in diamond solitaire sales and a shift to lower priced gold and silver products. Close margin for the quarter was 51.6% of sales versus 50.6% last year, a 100 point basis increase. Approximately half the margin improvement was a result of the continued shift towards direct sourcing of solitaire products and direct importer finished goods with the remainder being related to mix shift and the less promotional spance. We have been closely monitoring commodity prices to determine if price increases for gold products are warranted. Based on that review, price changes are planned in certain categories across our brands in the coming months to reflect gold increases and we are continuing to evaluate hedging opportunities. Merchandise inventory at January 31, 2006 was flat the last year at $967 million. And inventory turnover on a rolling 12 month basis was relatively flat at 1.25 prime. SG&A including the cost of insurance operations, expensing of stock options under Status 123R and executive severance costs was 34.8% for the quarter versus 32.6% last year as a percentage of revenue.

The Company recorded a charge of approximately $8.5 million before taxes or 11¢ per share for contractual cash, equity obligations related to CEO severance. The cash component is $3.6 million and the value of the stock options, restricted stock and other benefits component is $4.9 million. The Company recorded a charge of $1.6 million or 2¢ per share for compensation expense related to stock options in accordance FAS 123R which we adopted this year. Excluding the charge for severance, SG&A as a percent of sales was 33.9% versus 32.6% last year. The remaining increase was primarily the result increased investment in advertising, 90 basis points primarily in the Zale brand that did not result the increased and the inability to leverage increased expenses due to the short-fall in sales of 90 basis points, offset by a reduction in proprietary credit costs of approximately 50 basis points.

Operating earnings for the quarter including the impact of the executive severance expense and stock compensation expense was $149.6 million or 15.3% of revenue. Operating earnings for the quarter, excluding executive severance was $158.1 million, or 16.3% of revenues, versus 159.7% or 16.4% of revenues last year. The effective tax rate for the quarter was 30% versus 37% last year. The effective tax rate includes an $11.5 million or 23¢ per share income tax benefit resulting from the repatriation of foreign earnings under the American Jobs Creation Act. Excluding the repatriation impact, the effective tax rate for the quarter was 37.7%. The effective tax rate is higher than last year due to the impact of new stock options expense or incentive stock options that is not currently deductible. Net income for the quarter, excluding charges for the Bailey Banks & Biddle closed stores, executive severance, and the income tax repatriation benefit was $97 million or $1.96 per share versus a $99.2 million net income or a $1.91 per share last year. Including the Bailey Banks & Biddle store closure charges, executive severance and the tax repatriation benefits the net income is $88 million or $1.78 per share.

During the quarter, we opened 10 stores and 32 kiosks and carts. We closed 46 stores and 16 kiosks. Store closings include the 32 Bailey Banks & Biddle locations. We remodeled and refurbished 8 stores and 15 kiosks in the quarter. We ended the quarter with 2,654 locations as follows: Zales, 787; Gordon’s, 286; Bailey Banks & Biddle, 76; Outlet, 128; Peoples, 171: Peoples 2 Carts, 82; Piercing Pagoda, 824 and we have three Master Jewelry Repair (inaudible) locations. The capital expenditure plan is approximately $85 million for the fiscal year with a total target of 65 new jewelry stores primarily in the Zales and Gordons brands and 40 new Piercing Pagoda kiosks. 2.1 million Shares of Company stock were purchased under this buyback program this quarter for $55 million, completing the authorized total for the fiscal year of 100 million. At the end of the quarter there were approximately 48 million shares outstanding. The end of the quarter with $37 million is cash and borrowings of $120 million under the line of credit compared to $56 million in cash and borrowing of $136 million last year.

As Betsy stated, our revised estimates for the third quarter are flat but slightly positive comparable store sales and diluted earnings per share up 20¢ to 22¢. David and I will be available to discuss any detailed questions after this call. We will now open for your questions.

Operator

As a reminder, if you have a question, you may press star then the number 1 on your telephone keypad.

Your first question comes from Lauren Levitan with Cowan.

Lauren Levitan

Good morning. I have a couple of questions. Betsy, first I’m hoping you can reconcile the commentary that the Board is pleased with the overall strategy and the long term direction with the really dramatic review that you got under way in the Zales division and what sounds like an assessment that might lead you to take some pretty significant steps which would be in contrast to what you perceive the Zales division this last holiday season? So if you could help us reconcile that, that would be helpful. And then secondly, and related to that, could you please talk about what I understand that you are in the process of reviewing the Zales division and what you’d like to pursue there, but can you maybe give us some time frame over which we should be expecting progress, what we should be looking for and how we should measure that progress? And then lastly, I’m hoping you could just give us a little bit more color on Valentine’s Day, can we assume that the trend across the brands were pretty consistent, or did you see any improvement or deterioration of Zale relative to the other brands? Thank you.

Betsy Burton

Let’s start with the Board’s position with regard to our overall directions. The overall direction is that we have been losing market share consistently over the past several years and in the Zale brand and I think the belief is that we need to differentiate Zales from all the others. Now you walk in and almost all of the specialty retail stores look alike. So, that is the overall strategy in terms of the goal. I think the strategy if you would like to call it for the Zale brand was more of a repositioning going slightly away from our core customer, middle America, and essentially moving a little more upscale. We believe that was not the right direction so again, the Zale brand in terms of the brand repositioning is what the Board is not comfortable with for the long term positioning of the Zale brand. In terms of the review of Zales’ strategy, I think that John’s got a very successful track record in Canada, he’s been with us for five years. In fact, when he went to Peoples in Canada, it was in a turnaround situation. He’s done a quite effective job. He’s achieved comps per sales in excessive of 3% in gross for the consecutive four years and I don’t know if many of your know, but Canada was the one that lead the charge with regard to direct sourcing under John’s direction. He essentially has increased gross profit by 670 basis points since taking charge. We believe that John has a very clear vision of what need to get done, I think John is a very effective manager and is very quick to make those changes that need to be changed. I think we will be able to have John’s influence impact Mother’s Day which as you know is equal and important to Valentine’s Day. So I would suggest that our timeframe is conservatively cautious because, again, it’s difficult to effect all the moving parts, but beginning to see progress at Mother’s Day, but the real goal is to make sure that we get, have holiday and that we get it right for holiday. So that is the timeframe that we’ve been given or have given to John to try to affect at least the initial changes and seeing the results. Valentine’s Day was reasonably good. I think that it was again, in all of the brands except Pagoda, slightly positive. Again, Peoples was the star. So, we are comfortable with Valentine’s Day, and as you know that is very key to the quarter. So, again, we were cautiously optimistic about the quarter.

Lauren Levitan

Thank you.

Betsy Burton

Sure.

Operator

Our next question comes from the line of Adrian Shapiro with Goldman Sachs

Adrian Shapiro

Thank you. My question perhaps following on Betsy on the strategy, it sounds as if the merchandising strategy is being abandoned, but it seems that part of the flood tragedy was ushered in by the new marketing campaign and direct sourcing efforts which led to some of the missteps across the inventory issue. So, could you help us understand what part of the three prong strategy today is being abandoned? It seems that there’s only the merchandising part of the equation is initially being changed what it seems as that sticking with the marketing and direct sourcing would hamper the turnaround success? If you could help us understand.

Betsy Burton

Okay, good point. In terms of the merchandising mistakes, the biggest single one was, well there were two; one was being late in placing orders so we literally did not have the product, but the second was a conscious strategy to trade away inventory from diamond fashion and solitaires to fund investment in gold and silver. What we learned was that the customer wants the diamond fashion, wants the solitaire assortment in breadth and depth and because of that, that is one of the significant changes that we will be making in terms of the product mix changes that were made. Every aspect is being evaluated. The advertising campaign, you know not locked in stone, I think you know obviously, we won’t be able to impact Mother’s Day, but we will be taking a look at what that campaign should be. Should it be image? Should it be a combination of image and item price, and again that is under review. In terms of the inventory, direct sourcing is as I think you know possibly didn’t really get underway with the Zales brand. So I don’t believe the inventory misstep were caused by a shift in focus to direct sourcing as much as it was we changed out 30% of our product sku’s and 15% of our vendors and were late in placing orders at that, so I think our inventory problems were more self-inflicted.

Adrian Shapiro

Okay so direct sourcing is here to stay.

Betsy Burton

It is. And it’s still a big opportunity. We are currently only at about 5% of our total sales in terms of our direct sourcing of diamonds and we feel that potential is 20%-25%, so again, Zales brand just beginning and the Outlet not having even begun to direct source and as you know, the other component is what we call direct import which is finished goods and again, that therein lies the significant opportunity as well.

Adrian Shapiro

Could you just help us understand the advantages of direct sourcing? Given the scale advantages that Zale has in light of a lot of your competitors, clearly a lot of these retail stores having some pressure, what is the benefit of direct sourcing? It would seem as if the inventory risk perhaps outweigh it given the scale advantage that basically you and Kay dominate in the industry?

Betsy Burton

As you know, Kay also has direct sourcing and in fact, they are a little bit ahead of us in terms of their percentage direct sourcing, the real need is in terms of what I call the fashion product in terms of maintaining the relationship with vendors. There is significant margin to be had by direct sourcing. Having said that, direct sourcing is really most effective in terms of buying core basic assortments. In terms of fashion, you need the vendors in terms of design, innovation, technology, and more importantly, to share the risk in taking in the fashion assortment. So I think there is a scale advantage but you also have to recognize at the end of the day there are risks associated with direct sourcing and more importantly, you don’t want – it is good leverage with regard to negotiations with you key vendors.

Adrian Shapiro

Okay. Then my last question relates to you know tremendous amount of upheaval obviously in people and strategy and this was before the new CEO is found, so, Betsy are you staying on to see this ship righted? Or, you know when the new CEO takes the reigns we could see some continued disruption in the plan?

Betsy Burton

I am here for as long as it’s necessary to make a smooth transition and I think that we have the complete support of the Board and we will make sure that there is no disruption in terms of change of leadership.

Adrian Shapiro

Thank you.

Betsy Burton

Sure

Operator

Our next question comes from the line of Jeff Stein with Key Bank Capital Market

Jeff Stein

Morning guys. A question on the CEO search, what’s the timeframe we should be using and what are the qualities the Board is looking for?

Betsy Burton

Okay. The timeframe is we’ve said three to six months, but it could be two to three months. We are fairly far along in the search. As you know, we are looking at internal candidates as well as external candidates. In terms of what we’re looking for, we believe that it’s very important we get a well balanced executive. An executive that also recognizes the need to really develop a culture of participatory management teamwork and getting results. So we are clearly looking for someone that has a successful track record, but also has the personality characteristics to make this a great company again.

Jeff Stein.

Okay. And then second question is on the inventories. So how much of the comp miss was from bad inventory and how much of it was from just not having inventory? From shortages.

Betsy Burton

Sure, sure. I think not having product was by far the most cost us the most sales in terms of just basic product in addition to that though there was a significant shift away in terms of dollars in the diamond fashion category and as you know, going into holiday, the customer wants diamond fashion, not gold and silver. So I think those were the two drivers and I would probably assign equal weight to both.

Jeff Stein

Thank you.

Betsy Burton

Sure.

Operator

Our next question comes from the line of Mark Freidman with Merrill Lynch.

Mark Friedman

Thank you, good morning. Betsy I was just curious if you could further elaborate by putting John in charge of Zales, are you and the Board saying that as you look for a CEO, that person needs to be comfortable with John given the confidence you guys have put in him to make sure that this continues along the path, or is there some you know potential risk that the new CEO will have that flexibility to clean and start over again?

Betsy Burton

The Board feels very comfortable that any CEO that would be coming into the Company would actually want and applaud the move because by making the change now, we have the ability to impact Mother’s Day or learn from Mother’s Day and impact holiday. And we felt it was more critical to do that than to wait to have a CEO in place. I think that again, knowing John’s personality as well as his track record, we in the Board, felt very comfortable that John is the right person and that the new CEO would agree with that decisional.

Mark Friedman

Thank you. On Pagoda, clearly Italian charms are very successful product that’s putting most of the pressure I would assume on the business. Is there anything else you can elaborate about Pagoda and what is being done there to rejuvenate the business?

Betsy Burton

Sure. As you know, Italian charms are significantly declining even though they are still in our assortment. We are looking for the next great idea, but quite frankly, there is not one out there. We are testing a couple of things that have promise. In particular cell phone charms and we are just beginning in terms of costume jewelry and have some pretty good results from our preliminary tests, but it would be premature for me to tell you that we actually have a replacement for Italian charms.

Mark Friedman

Thank you.

Betsy Burton

Sure.

Operator

Our next question comes from the line of Mark Bedinger with Stanford Group.

Mark Bedinger

Hi everyone. Mark a couple of real fast questions on the numbers. The $48 million in the share account, is that fully diluted?

Mark Lenz

That’s the outstanding.

Mark Bedinger

Okay, what would fully diluted be going forward?

Mark Lenz

We’re expecting it to be in the $49.3 range give or take for the outgoing quarters.

Mark Bedinger

Okay. And the 32 Bailey Banks & Biddle closing, what decrease third and fourth quarter in sales should we expect. In other words, what were they responsible for, for third and fourth quarters?

Mark Lenz

They were responsible for hold on I’ll get back to you with those numbers, Mark.

Mark Bedinger

Okay. No problem. In terms of John, I think you mentioned that he has a clear vision, do you know what changes he wants to implement when he hits the ground running here?

Betsy Burton

As you know, this is day 1 of his job, so we really haven’t had a lot of conversation about it but my belief is, he has a very successful product assortment in Peoples target customer, is the same as Zales target customer so I would suggest that any of the changes would probably be to play upon the success at Peoples.

Mark Bedinger

Okay, so you think most of the clear vision that you’re referring to is largely in the form of product assortment?

Betsy Burton

Yes.

Mark Bedinger

Okay, so then the in-depth review that’s going to occur, how long to you expect that to take place?

Betsy Burton

It’s on-going, again, I think there will be some decisions that will be made very quickly and I think because of the time table, to have finished advertising for holiday, there is some pressure to make those decisions sooner than later.

Mark Bedinger

Okay. And you’re belief is that the CEO that’s going to come in is basically going to need to be on board with these changes that will have already taken place?

Betsy Burton

It is our belief that if it’s the right thing for the Company that we cannot wait until we get a CEO on board and we are very clear that this is the right direction.

Mark Bedinger

Okay, so in your term and until you bring in a CEO it looks like following John’s vision and what he implements is the way we should be viewing the way the Board thinks this is the way the Company will be going?

Betsy Burton

That is correct.

Mark Bedinger

Okay, and how and maybe this needs to first be determined, but the goal to differentiate Zales from its competition, I mean any sense of how that might be accomplished?

Betsy Burton

We do have good ideas about that in terms of as you know, all jewelry sort of look alike, and it’s a combination of product, a combination of introducing in-store elements whether it’s signage, display, and more importantly with our in-store experience and our sales associates in through training, so I think it’s a combination of everything. It’s not one magic bullet. But, we do think that in product assortment is one way in which also believe we can step apart from the pack.

Mark Bedinger

Okay, and Mark, just again, what was the square footage growth did you say in the quarter?

Mark Lenz

1.4% and to your other question, the answer is about $12 million per quarter on sales impact to the close Baileys stores.

Mark Bedinger

$12 million. Okay and then on the $24 million for the Baileys Bank & Biddle, I think you broke it down at $6.2 would be in the cost of goods sold and $18 million SGNA?

Mark Lenz

Right.

Mark Bedinger

Okay and the $8.5 million was all SGNA, correct?

Mark Lenz

The $8.5 million for the severance, yes.

Mark Bedinger

For the severance and then the $11.5 million was just added to the tax that you have?

Mark Lenz

Correct.

Mark Bedinger

And that you get us to the $196 million.

Mark Lenz

Yes.

Mark Bedinger

Okay, great. Thank you very much.

Operator

You next question comes from the line of Bill Armstrong with CL King and Associates.

Bill Armstrong

Yes, good morning. I guess just a couple of other merchandising questions. So I guess how do you know that the value component has been the problem here in terms of losing market share, and I guess related to that, who do you think you’re losing market share to, and you also mentioned that your customers clearly wanted diamond fashion for the holiday season versus gold and silver, so how is it that, that decision was even allowed to be made to deemphasize diamond fashion if that’s I guess a clearly a category that’s in demand during holiday? Thank you.

Betsy Burton

Sure. Let’s talk about the value component. It’s very clear when you look at our drop in sales, you can look at the fact that we decided to not anniversary key promotions really cost us a lot of momentum in sales. So it’s very clear that the customer was used to that promotional activity. In addition to that, as you know, our brilliant buys have been part of our strategy in terms of key item pricing promotions. And by taking that away, we did not offer as good a value proposition as we had historically. In terms of who we’re learning market share to, obviously, Kay’s market share has increased so we obviously have lost – continue to lose market share to Kay’s. In addition to that, JC Penney’s really becoming a big player in the jewelry market. They clearly have become an increasingly viable competitor. You’ve also got Wal-Mat, Target, Cosco, so everybody is getting into what I call the moderate price jewelry. So it is very competitive market out there. In terms of diamond fashion and the decision to deemphasize it I obviously wasn’t here but I believe that their decision was a mistake and I think they would agree with that now.

Bill Armstrong

Okay. Just a couple other quick ones. John Zimmerman is coming in, it looks like he’s got a good background, some good ideas, now a year ago I think it was, Paul was elevated to the Zale Division presidency after having had some success at the Pagoda Division, so I guess what gives you confidence that John’s going to have better success than Paul given that this is clearly you know a much bigger responsibility than he’s had thus far?

Betsy Burton

Okay. Again, I think that the decision to make Paul the President you know clearly was a decision that was made by the prior CEO. I think that based off of somewhat of a mixed track record, I think that, that was a bit more of a risk, but given John’s very strong track record, without having any hiccups, I think we feel very confident that John is the right person to lead the brand and obviously if we could wind back the clock we would have made him the brand President a year ago.

Bill Armstrong

Okay, and then just a clarification on earlier comments you made, you said 5%, your direct sourcing about 5% of your diamonds, gold is 20%-25%, is that for the Zale division or is that for the Company as a whole?

Betsy Burton

Company as whole. And because of that you know, the very large amount of diamond sourcing done by Peoples and Gordons, you can infer that Zales and Zales Outlet are at the low end, bringing that average down.

Bill Armstrong

Alright. And then just one final housekeeping question. Will there be in your guidance for Q3 of 20¢ - 22¢, is there any severance charge for Paul Leonard built into that number?

Betsy Burton

No. He was terminated after the quarter closed, I’m sorry for second quarter, but there will be a charge for third quarter.

Bill Armstrong

There will be. How much? Do we know yet?

Betsy Burton

It’s under $1 million.

Bill Armstrong

So is that, that’s included in your guidance then?

Betsy Burton

Yes.

Bill Armstrong

That’s part of the guidance?

Betsy Burton

It is included.

Bill Armstrong

Okay. Thank you.

Betsy Burton

Sure.

Operator

Your next question comes from the line of Dax Lassus with Gates Capital Management.

Dax Lassus

Yes, I was just curious if you could tell us you know the reduced promotional cadence, what sort of impact it had on gross margins and in addition, as far as your gross margins go, can you talk about the impact you expect from going from 5% of your direct sourcing to 20%-25%?

Betsy Burton

Sure. We believe that in terms of the reduced promotional cadence that there was a slightly higher gross margin but it was also due to a change in mix and in addition to that, reduced mark downs. So it’s not just reduced promotional activity. But again, you know, our concern is more gross margin dollars and the sales miss. And there were some promotions last year that were very promotional, very sharply priced. So yes there was a little bit of benefit in terms of gross margin. In terms of the direct sourcing, we believe that we can continue to realize another 50 basis points with improvement over the next, each of the next several years due to direct sourcing.

Dax Lassus

Each of the next few years?

Betsy Burton

Yes, two to three years clearly. As I say, we’re just beginning with regard to the Zale brand and Outlet has not even begun, so there is some low hanging fruit that we believe we can achieve over, again, the next two to three years.

Dax Lassus

Would the benefit from that be reinvested in opportunities to increase your sales like whether it would be promotions or just sort of discounting?

Betsy Burton

There are opportunities to reinvest across the board. Again, we’re focused on dragging the top lines but that doesn’t mean necessarily increasing marketing dollars, it’s more effective use of marketing dollars. We do need to invest more in our stores, in our people, so we are and as well as you know giving stores a little bit of a facelift. So we will be reinvesting dollars. Not in – not necessarily just in marketing, but throughout our store brands.

Dax Lassus

Right. And my last question is with respect to the change with John coming over to the US. Is there structural differences in the market between the US and Canada? I was under the impression that Canada is a less competitive market than the US. Is that a fair statement?

Betsy Burton

I think they both have their competitive challenges. We have a very large market share in Canada. We’re about 20%. So I think the significant difference in the share of market, but there is still competition independence, lots of you know you have to be competitively priced. I think in terms of structural differences, I mean, obviously, we buy the same product. There are differences in terms of how we buy, but I think that there are more similarities than there are differences particularly in the target customer and the offering.

Dax Lassus

Would it be fair to say that the improvements in Canada were somewhat easier to make given the higher market share there?

Betsy Burton

I’m not sure I would say easier. I think, if anything, the Zale brand because it’s had it’s missteps, might actually be the easier one to see results.

Dax Lassus

Okay. Betsy, are you one of the candidates being considered for the CEO permanent position?

Betsy Burton

No. I am not. And this is not what I do for a living. So, no.

Dax Lasus

Okay. Thanks.

Betsy Burton

Thank you.

Operator

The next question comes from the line of Robin Merchanson for Sun Trust.

Robin Merchanson

Hi, good morning. Can we assume that you’re pleased with the currency of your inventory? And secondly, how you know I keep seeing these signs in the malls, 30%-60% off at the Zales store, very visible from – you know the walkway in a mall. They’ve sort of been out there for a long time, clearly I presume you want to wean your customer off of that mentality, how would you plan to do that?

Betsy Burton

I think that the 30%-60% off was more of a response to the lack of momentum from the lack of promotional events as well as the brilliant buys. I think what we intend to do is you know bring back the everyday values so that it’s not necessary to continue to you know put the 30%-60% banner up. I think that the important thing will be to make sure we have a promotional calendar that reflects what our customer when our customer wants to shop and make sure that we are promotional on the products that they want.

Robin Merchanson

And currency of inventory?

Betsy Burton

In terms of?

Robin Merchanson

In terms of ...

Betsy Burton

Quality?

Robin Merchanson

In terms of markdown risk, are you fairly current on your inventory? Meaning that little of it you feel is at risk?

Betsy Burton

We have made tremendous inroads going into holiday and coming out of holiday. So I would say we’ve moved probably 40-50 million of what was discontinued in clearance out. We feel very good that we are, we do not have an inventory problem. Again, if anything, the problem was on the reverse which was too light.

Robin Merchanson

Thank you very much.

Betsy Burton

Sure.

Operator

The next question comes from the line of Harry Eichenson of Noland Berger Capital.

Harry Eichenson

Good morning. Thank you. Two fold things. During the discussion talking about client prices then reviewing and possibly making change on prices going forward next 6 to 12 months, could you elaborate on that? And then second, you talked a lot about direct system usage finished supplier goods and there is opportunity there, so could you elaborate on that? Thank you.

Betsy Burton

Sure. In terms of the price changes, as you know with the gold that we own is worth $450 and gold could go up to $550 plus, so we are looking at price changes for competitive reasons I won’t talk about the rollout, but it is something that we are beginning to see in the marketplace and feel comfortable we can begin to raise our gold prices as well.

Harry Eichenson

Does that mean you feel that you’re behind the competitors, that they’ve raised it already? Or what give you comfort?

Betsy Burton?

Well, we are beginning to see competitors raise prices. That means, no we’re not behind, we don’t want to be the leader in terms of being priced uncompetitively, but I think everyone is facing the same pressure and beginning to look at when the have to re-buy what the cost would be and we need to be ahead of the curve to make sure we maintain our margins.

Harry Eichenson

Okay.

Betsy Burton

In terms of direct sourcing, I think initially we were very excited about what the diamond solitaire business in particular is the opportunity in direct sourcing, but it also has become evident that we can work with vendors to direct source basic product which is finished goods and that, that has the potential to be even larger than the diamond direct sourcing.

Harry Eichenson

So with that being said, is that in your estimates also going toward long and term and you were talking about direct sourcing or is this a separate piece?

Betsy Burton

No that’s the combined guidance that I gave you of 50 basis points a year for the next two to three years, includes direct imports.

Harry Eichenson

Okay. So it includes finished goods.

Betsy Burton

Right.

Harry Eichenson

Okay. Good luck. Thank you.

Betsy Burton

Thank you.

Operator

Again, if you have a question, you may press star and the number one on your telephone keypad. We have a question from the line of Brian Tunic with JP Morgan.

Brian Tunic

Yes, a couple of questions. First one. If you’ve done a benchmarking between Kay and yourself, and it sounds like you think the two biggest gaps are training and product, is that fair, Betsy?

Betsy Burton

I think training in terms of quality of associates and a third I think would be they do have a significantly higher marketing spend.

Brian Tunic

Okay. Compared to what you’re spending in the fourth quarter?

Betsy Burton

Correct. And there’s a fairly substantial delta in terms of pay scale at store level.

Brian Tunic

Cause it looks like the average store volumes are pretty similar, so it’s just interesting there. Okay, then Betsy, as far as the Board goes, does the change in leadership and strategy, does that change the Board’s view on approving another buyback program to use the fee cash flow?

Betsy Burton

Good question. I think you know, historically, at the beginning of the fiscal year is when we announce buyback because it doesn’t really make sense because of the low earnings for the quarters three and four. So I would anticipate that we would make an announcement again at the beginning of the next fiscal year in August.

Brian Tunic

Okay. And then just finally, any comment or color on on-line sales?

Betsy Burton

On-line sales are continuing to almost double. We are getting very good results. We had a good Valentine’s Day, we did just bring on a dedicated e-Commerce person at a very high level that is going to spearhead some changes in terms of improving the navigation functionality of our website. As you know, we don’t even have a Gordons website, but we want to perfect the Zales brand first, make sure the Baileys website also benefits from some of the features and enhancements that we want to make. And our goal is to make those features and enhancements so that we will have a great holiday fiscal ’07.

Brian Tunic

Is there any way that you’re measuring conversion of people that come on the site to the store?

Betsy Burton

Yes we measure conversions. We measure traffic and we measure satisfaction. And quite frankly, we score low on all of the above and because of that, we’ve identified the changes, the causes of why we lose people and are rapidly working to work with our partner (inaudible) to make those changes.

Brian Tunic

Terrific, thanks. Good luck with everything.

Betsy Burton

Sure.

Operator:

Your next question comes from the line of Mark Friedman with Merrill Lynch.

Mark Friedman

Hi, Betsy, I haven’t heard from Sue today, I’m wondering any changes to her role, anything going on as it relates to what Sue’s doing during this transition?

Betsy Burton

Sue has been extremely helpful and is very engaged and very involved working side by side with me, so do not read anything into the lack of voice from Sue.

Mark Friedman

Okay. Good to hear that. Thanks.

Betsy Burton

Sure.

Operator

The next question comes from the line of Robin Merchanson with Sun Trust

Robin Merchanson

Hi. Just a follow up. Are you pleased with the portfolio of Zales stores? Any thought to closing any of them or is that under review or just going to continue same as usual (inaudible) and there?

Betsy Burton

We are always reviewing stores. We call them endangered species. But I would say there’s not a lot of stores out there. I think there were some tests that potentially we may end up trying to close some of those stores, but not a great buzz. There’s not a large chunk of stores that we consider are underperforming.

Robin Merchanson

Thank you.

Betsy Burton

Sure.

Operator

The next question comes from the line of Harry Eichenson with Noland Berger Capital

Harry Eichenson

I just wanted to follow up on Brian’s question. You were talking about on-line and then in measurements you were talking about conversion, traffic and satisfaction. When you refer to on-line is that point, or stores?

Betsy Burton

On-line.

Harry Eichenson

Okay. That’s what I thought. And you said they were all unsatisfactory?

Betsy Burton

Well we are not happy with them.

Harry Eichenson

You are not happy. Okay. Secondly, at the store level, are you tracking conversion at the store level yet?

Betsy Burton

In terms of people that walk in and how many convert to transactions?

Harry Eichenson

Right.

Betsy Burton

It’s very difficult. We don’t really have a metric to track who comes in and doesn’t buy.

Harry Eichenson

I thought the Company was planning on putting that stuff in a year or so ago. That it was in the works.

Betsy Burton

In some Baileys, not Zales.

Harry Eichenson

Is that not on the drawing board at all?

Betsy Burton

Not at the present time.

Harry Eichenson

I think that would be an important metric to know in reference to getting your merchandise right.

Betsy Burton

I think part of what we’re trying to do is focus on the sales associates is so key to closing a transaction and that we are really putting our efforts and energies into training because typically a customer will show all four corners and then go back to the jewelry store where they have the best relationship with that associate. So we believe we need to start by looking at training our associates and doing a better job of managing and developing relationships.

Harry Eichenson

Any specifics along those lines that you can do other than just training on how you’re going to help build that?

Betsy Burton

Well we are looking at perhaps sweetening the commissions, sliding scale commission and other things which clearly would help them incentivize our associates to close those sales and you know so we are trying to give them all the tools and the right incentives to make that happen.

Harry Eichenson

Okay. Thank you very much.

Betsy Burton

Sure

Operator

The next question comes from the line of Bill Armstrong with CL King and Associates.

Bill Armstrong

Just a quick follow up for Betsy. In your opening comments you mentioned that you walked away from $22 million of promotional events in November and December. Could you just elaborate on what that was and what the $22 million represents?

Betsy Burton

Sure. One key holiday, Veteran’s Day, we decided not to anniversary. Not to promote. That was a big mistake. Pre-Thanksgiving, we pulled a promotional even. And then in December we had bonus buys and one day sales that we decided not to anniversary and the sum total of all of those meant about $22 million of lost sales.

Bill Armstrong

And you know that because that’s what those events generated the year before?d

Betsy Burton

Right, yes.

Bill Armstrong

Got it. Thank you.

Betsy Burton

Sure.

Operator

Your next question comes from the line of Mark Bedinger with Stanford Group

Mark Bedinger

Hi. I just wanted to know if the product assortment changes, if that includes still a focus on an increase in quality?

Betsy Burton

Yes. I think we do recognize that over the past several years the quality was not necessarily as good because we were trying to maintain our competitive price points. So we have – we do still believe that we need to make sure that we are in a comparable level quality, but that we don’t move up too far on the quality scale to make sure that we still remain competitive.

Mark Bedinger

So in that balance, where do you see, I mean obviously you’re always going to be competing with Kay, but I terms of Wal-Mart and Target, where do you see you know the Company being placed relative to them?

Betsy Burton

Our quality will be better than Wal-Mart and K-Mart, and our quality will be equal to Kay’s.

Mark Bedinger

Okay. Thank you very much.

Betsy Burton

Sure

Operator

Our next question comes from the line of Jason Asada with Standard & Poors Equity*

Jason Asada

Hi, good morning. In terms of Zales and the new products that have been introduced over the past few months, have there been any new products that have performed well? And secondly, I guess in terms of the off mall Zales Outlet concept, could you provide an update on that?

Betsy Burton

Okay. In terms of new products. We had a huge home run with the circle pendant which was a diamond pendant that just blew off our shelves and we continue to expect it to do quite well at Mother’s Day. And we continue to see opportunities in terms of not only the 3-stone rings but the evolution to what’s called the Journey which is DeBeers introduction for Fall which is a diamond drop 5-stone necklace. So we do feel that there’s some exciting product out there. In terms of I believe you asked about the off mall concept for Outlet?

Jason Asada

Yes, that’s right.

Betsy Burton

We have put that on hold. We had good results in one market and very bad results in another market, so have decided that that is not necessarily an opportunity for Outlet and more importantly, I don’t think the opportunity is as big as we had expected due primarily to the radius clauses in our existing mall, Zale mall store leases.

Jason Asada

Okay. Thank you very much.

Betsy Burton

Sure.

Operator

We have no further questions at this time.

Betsy Burton

Thank you all for your participation.

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