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Executives

David Sternblitz - VP and Treasurer

Neal Goldberg - President and CEO

Rodney Carter - EVP, CAO and CFO

Gill Hollander - EVP and Chief Sourcing and Supply Chain Officer

Analysts

Lorraine Maikis - Merrill Lynch

Janet Kloppenburg - JJK Research

Adrianne Shapira - Goldman Sachs

Bill Armstrong - C.L. King & Associates

Jeff Stein - Soleil Securities

Evren Kopelman - JPMorgan

Chia Kuo - Telsey Advisory Group

David Mann - Johnson Rice

Zale Corporation (ZLC) F3Q08 (Qtr End 04/30/08) Earnings Call May 22, 2008 9:00 AM ET

Operator

Good morning. My name is Hillary, and I will be your conference operator today. At this time, I would like to welcome everyone to the Zale Corporation Third Quarter 2008 Earnings Call. (Operator Instructions)

I'd now like to turn the call over to Mr. Sternblitz, Vice President and Treasurer of Zale Corporation. Sir, you may begin your conference.

David Sternblitz

Thank you, Hillary. Good morning. And thank you for joining us for our third quarter conference call. As already said, I am David Sternblitz, Vice President and Treasurer of Zale Corporation. With me on the call today are Neal Goldberg, President and Chief Executive Officer; Rodney Carter, Executive Vice President, Chief Administrative and Chief Financial Officer; Theo Killion, Executive Vice President of HR, Legal and Corporate Strategy; Gill Hollander, Executive Vice President and Chief Sourcing and Supply Chain Officer; Steve Lang, Group Senior Vice President and Chief Merchandising Officer; and Cindy Gordon, Senior Vice President and Corporate Controller.

Before we begin, I'd like to review the Safe Harbor statement.

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

Information concerning some of the factors that could cause actual results to differ materially from those contained in the forward-looking statements is available in our annual report on Form 10-K for the year ended July 31, 2007, and our quarterly report on Form 10-Q for the quarter-ended January 31, 2008.

In addition, we may present non-GAAP financial information on this call. For reconciliation of each non-GAAP financial measure to the most directly comparable GAAP financial measure, please refer today's earnings release, which can be found on our corporate website www.zalecorp.com under Financial Information and then News Releases.

I would now like to turn the call over to Neal.

Neal Goldberg

Thank you very much, David. This morning, I would like to provide you with an overview of developments during Q3 and progress we have made towards achieving our goals. On our previous call we discussed these three principal components of our plan. In general, I am very pleased as we have made down payments on these key initiatives, which include: First, focus on our core customer like clarifying our merchandise offering, improving our value proposition, and simplifying our marketing message which is led by product and supported by price.

Second, enhance our operational effectiveness through the implementation of our efficiency program and the appropriate alignment of our organizational structure.

Third, maintain financial rigor and discipline by executing on our inventory liquidation program, generating substantial savings on expense reduction initiative and returning value to shareholders through a significant stock repurchase program.

We captured market share with a quarter's nearly 6% comp, driven primarily by an aggressive clearance program that exceeded our expectations and liquidated 55 million of clearance inventory.

Our stronger performance at the top-line, combined with the slightly more favorable gross margin resulted in a $0.42 million EPS loss for the quarter, warranty adjusted EPS with a loss of $0.17. We have discussed our valued focus and importance of reengaging our core customer.

The comp stores increase demonstrates our ability to drive traffic into our stores and reestablish our relationship. The third quarter was about much more than an implementation of the inventory reduction program.

As part of our customer focus, our management team spent a significant amount of time in stores and markets across the U.S. and Canada during the quarter, with the goal of gaining a deeper understanding of our customer and our associates who serve them, as well as identifying areas we need to improve.

The time we have spent in the field reinforces our belief that focus and clarity in the merchandise presentation and marketing is paramount to improving the customer experience.

We have been over sorted in the past, reducing our skew bases critical to improving the clarity of our offering. With the success of our clearance strategy, we have already started to create cleaner statements in our cases. By simplifying what the customer sees and focusing on merchandise statement on the good, better, best value proposition, we are beginning to differentiate our offerings.

Quality is an equal importance to our customer and we are focusing on improving our product quality across all categories. I will speak more on this later.

Towards the end of the quarter, we began flowing in some new product and are encouraged about the early results to Mother's Day. Our testing process for Mother's Day was more robust than in past years, specifically related to the amount of new merchandise.

We took advantage of the traffic generated from the clearance strategy to assess new goods and gain important learnings. This level of testing is critical before building our new assortments for holiday. I spoke in the last conference call about the expansion of our customer-experienced pilots. Our learning's from these pilots have been incorporated into what we are calling our pacesetter stores. The pacesetter stores have been identified and prioritized, due to their overall strategic importance and their potential to drive the best profit contribution. These 135 stores generate approximately 20% of our revenue and have an even more meaningful contribution to our earnings.

By channeling our resources, focus and intensity on these stores, we will have the greatest impact, while continuing to make modification for the rollout to the entire fleet. Investment in these stores consists of heightened management focus, enhanced assortments, merchandise presentation, aesthetic improvements and increased level of training. We also conducted a compressive review of staffing in these stores. Our goal is to have the best people, product and presentation to drive the best performance in our focused group of stores that we know we can impact. We will be speaking more about these pacesetter stores in the future, as a remainder of their progress and further develop the program.

Along with the pacesetter stores, our marketing message has been simplified and integrated across multiple touch points on the customer experience. The in-store presentation is cleaner and more visually pleasing. Signage has been reduced greater clarity of message. Color was added to the element in this showcase highlighting Mothers Day, and was recently changed to signify the summer season. These visual changes enhance the look and feel of the store, and are only the beginning of changes we make ourselves more compelling to the customer.

The Mom Rocks marketing campaign from Mothers Day was integrated across all channels, including television, print, catalogs, in-store, direct mail and online. We are creating an emotional experience that resonates with our customer. To that end, the most recent Mom Rocks TV campaign, combined the celebration of Mom with product and built on brand trust by emphasizing our long history with the tag line: America's Diamond Store Since 1924. The response has been very positive, and by focusing on emotion rather than price, we are connecting more quickly with people compared to previous campaigns.

We have received great feedback from all our key constituents; employees, customers and investors. If you do not get a chance to experience the TV campaign, I encourage you to go to the investor relations page of our website, where we have the commercial posted for you to view.

We also had a key senior management addition during the quarter, with our hiring of William Acevedo as EVP and Chief Stores Officer. William, with his dedicated leadership will help improve the in-store customer experience and drive better execution. Also, his 18 years of store operations and merchandising experience in Banana Republic and Macy's, will help support the second component of our plan, enhancing our operational effectiveness.

I've spoken about the ability to stay nimble, quick and agile, and I believe we have taken steps to build a stronger leaner organization better equipped to focus our important customers. These changes are helping us to connect better with both our associates and customers, increasing communication and cooperation across brands. The company is no long structured with five independent silo brands that have separate organizations supporting each of them.

With the hiring of William as Chief Stores Officer, we now have key executives at the head of each functional area. These are dedicated people analyzing our business across all brands, focused on improving efficiency and execution companywide. This aligns us as one team with better customer focus, working together on shared goals that have increased visibility and accountability throughout the organization.

Within this new organizational structure, we have strengthened the distinct roles of our merchandizing and sourcing organizations. I've spoken previously about freeing up our margins to focus on building assortments, starting our business and evaluating the competition. Beyond giving us greater insight in to our customers, this allows us to be more plan full with our merchandise purchases. We are going to market earlier, developing more consistent forecasting. Reflecting our commitment to excel at sourcing, the sourcing and quality team, and I recently spend a week in India and China meeting with some of our key vendors.

As we have discussed, quality will not be compromised in our effort to focus on the customer. And on this trip, I communicated that message to some of our key vendor partners. We recently added Eric Christopher as VP of Quality Assurance. Eric will play a critical role in the execution of our merchandising and sourcing initiatives. He spent the last 16 years at QVC Nordstrom sourcing jewelry products, with a deep focus of quality assurance. As we continue to narrow our vendor base, we are creating efficiencies and partnering with vendors best suited to provide to quality products at the best overall cost.

We have already reduced our vendor base by 50% since January. By partnering with select vendors, we are giving them more consistent purchase orders and longer lead times, further supporting our initiatives to receive better quality product and improved cost efficiencies. Finally, our commitment to financial rigor and generating free cash flow was evident this quarter. It is important to maintain a solid financial foundation.

I mentioned the expense reduction initiative. Our infrastructure costs were outpacing sales growth since 2002. It's important for us to take out redundancies and create efficiencies to ensure streamlined origination that can execute in any environment. We identified $65 million plus in ongoing annualized savings. We recognized that expense saves will help drive efficiencies in the near term, but our ultimate success will come from optimizing the balance between top-line growth, margin expansion and expense control. We are committed to fostering a culture of cost discipline and accountability.

I indicated that our aggressive inventory clearance program exceeded our expectations and we now expect a clearance reduction of approximately a $120 million. This is essential to improve our merchandise presentation going forward.

Reduction in inventory and the decrease in the number of overall skews will help clarify offering as well as improve the good, better, and best value proposition. Additionally, the inventory liquidation increases cash flow generation, adds flexibility and improves inventory efficiency.

As the clearance strategy exceeds $100 million, we will make investments in diamond and proprietary products, which have resonated very well with our customers thus far. These investments are consistent with our focus to be the best in diamonds, and grow our bridal business.

We discussed anticipated impact of our clearance strategies for the back half of the fiscal year, while it may get a little more aggressive, we are well on track to achieve our objectives. Additionally, we previously announced store closings for the fiscal year '08, as part of our ongoing real estate review, to evaluate opportunities based on return on capital. Also capital expenditures were reduced by $40 million for fiscal year '09.

While preserving flexibility, we have also freed up a significant amount of capital this year. This provided an opportunity to enhance shareholder value, with 250 million of stock repurchased during the fiscal year, which equates to a 28% of our outstanding shares.

Rodney will expand on each of these in greater details in his comments.

Our financial condition is solid. We have strong cash flow and a solid balance sheet that provides flexibility to take advantage of opportunities that may present themselves. It is imperative that we maintain the same level of financial rigor and discipline regardless of the economic environment.

In summary, we are very pleased with our progress to-date against our plan. We achieved our objectives in the third quarter and have carried this momentum into the fourth quarter. We were pleased with Mother's Day as the trends in the business remained similar. We've recognized there is more to do as we strive to exceed the expectations of our value-oriented customer, enhance operational effectiveness and maintain financial rigor and discipline.

We have a focused agenda along with a sense of urgency to improve performance and we are staying locked in on achieving these objectives. We must continue to execute to capitalize on our opportunities. I am confident we are taking the steps to do just that.

Now I would like to ask Rodney to review our third quarter performance and provide further financial details. Rodney?

Rodney Carter

Thanks, Neal, and good morning, everyone. My comments will relate primarily to the financial results of the third quarter and the financial progress against our plan. As previously discussed, the sale of Bailey Banks & Biddle was concluded on November 9, 2007 and the brand's performance has been isolated and reported as discontinued operations on the page of the P&L for the three and nine months ended April 30, 2008 and 2007 respectively. The following are the key statistics for the third quarter of fiscal 2008.

Comp store sales increased 5.8%. All brands reported increases except Outlet, which was slightly negative, driven primarily by the performance of the destination centers. Total revenues were $477 million, compared to $449 million, an increase of 6.2%. The average transaction was relatively flat and $175 million compared to $172 million last year.

Reported revenue reflects a $3 million increase in recognized revenue from warranties. This trend should continue as we begin to anniversarise the change in the product offering. Unrecognized revenues from warranty sales increased $17 million from the end of Q2, and we continue to see strong attachment rates and for Q3 a 52%. Our customers' response to the lifetime product is encouraging, given the focus on clearance over the past three months. This brings the year-to-date increase of unrecognized revenues to $64 million.

As we have previously discussed, during the holiday period late last fiscal year, we extended the service period for the warranty plan offered to our customers from two years to the lifetime of product ownership, both simultaneously raising the retail price. Our actual sales continue to increase over the comparable prior year period. Revenues have been negatively impacted due to more revenue being deferred.

We believe that the net change in unrecognized revenues will consistently provide insight into the incremental cash and the potential impact on future earnings. In addition to the generation of cash, the deferred revenue generated will be recognized over a significantly reduced share count resulting in a substantial future EPS benefit. Gross margin for the quarter was 47.5% of sales versus 52.1% last year, a reduction of 460 basis points.

On the second quarter call, we talked about our blended gross margin compression of approximately 500 basis points over the third and fourth quarters combined related to the clearance initiative.

Our results are in line with expectations and we anticipate fourth quarter margins to experience a similar high reduction as we move through additional inventory. As Neal indicated, we are ahead of expectations regarding the inventory initiative. And during the third quarter we liquidated $55 million of the $100 million that has been identified to be permanently reduced. We will continue to evaluate our inventories for underproductive skews on an ongoing basis to enhance the clarity of our offerings, the overall inventory efficiency, fund investments in new higher productivity inventory, and to generate cash flow.

Merchandise inventory at April 30, 2008 was $867 million versus $1.1 billion last year, a decrease of $220 million. Prior year inventory includes approximately $166 million related to Bailey Banks & Biddle. Excluding Bailey Banks & Biddle, inventory was down approximately $53 million as a result of the clearance initiative. Inventory turnover on a rolling 12-month basis was slightly lower at 1.15 times this year versus 1.21 times last year.

SG&A, including the cost of insurance operations, was 49% for the quarter, versus 49.9% last year as a percentage of revenue, primarily due to leverage generated as a result of the sales increase. SG&A dollars increased by $10 million, primarily in variable fields of payroll and rent. The company achieved approximately $4 million in savings related to the expense reduction initiative that was offset by $2 million of severance and related expenses. Operating loss for the quarter was $21.9 million, compared to a loss of $4 million last year.

The effective tax rate for the quarter was 26.4% versus 38.6% last year. For the year, the effective tax rate is estimated at approximately 50%. The increase on an annual basis in the effective tax rate is primarily the result of the relationship of non-taxable earnings in Canada, to the consolidated loss, as a result of our APB 23 election to permanently reinvest the funds. The tax rate is expected to normalize to historical levels next year. The net loss for the quarter from continuing operations was $17.4 million or $0.42 per share, compared to a loss of $5 million or $0.10 per share last year.

As adjusted for cash warranty, the net loss for the quarter was $7 million or $0.17 per share compared to net income of $4.8 million or $0.10 per share. Earnings per share this quarter were negatively impacted by $0.07 due to the tax rate, and $0.06 as a result of the reduced share count from the stock repurchase program. The strong emphasis on enhancing shareholder value continues to be evident by our share repurchase program.

We announced a $200 million authorization in November of 2007, and an additional authorization of $100 million in March of this year. The combined repurchases are being funded primarily by the proceeds in the Bailey Banks & Biddle divestiture, and the reduction in inventory levels. Through May 2 this fiscal year, we have repurchased 250 million of stock, or 13.8 million shares, or 28% of the outstanding shares.

The first $100 million of our authorization was accomplished through an accelerated share repurchase agreement totaling 5.9 million shares at an average price of $16.85. Additionally, we repurchased $150 million, or 7.9 million shares at an average price of $18.98, as part of our 10b5-1 program, for total average price of $18.06 for all shares purchased. In the third quarter, we purchased 7.9 million shares, which includes 1.6 million shares in the Romanian settlement from the ASR, and we repurchased or purchased another 160,000 shares in the first week in May.

We now have approximately 35.5 million shares outstanding. We have $50 million in authorization remaining and we intend to remain opportunistic and flexible regarding further repurchases. The share repurchases are expected to be highly accretive over the coming years. The significant share repurchase program was executed without increasing overall debt levels or limiting the company's financial flexibility.

Due to the lack of sales growth over previous years, some of our fixed expenses such as payroll and rent have been deleveraged. During the quarter, we announced our operational efficiency program and the plan to generate $65 million plus in annual savings. These savings initiatives continued financial discipline, and accountability should result in decreased SG&A expense as a percentage of sales in the coming years.

We ended the quarter with 2139 locations, consisting of 1391 stores and 748 kiosks. As previously mentioned, we have closed approximately 105 locations in fiscal 2008. This will result in a net reduction of two jewelry stores. While the closed stores were cash flow positive, they did not provide an opportunity for an attractive return on capital.

We will continue to take a consistent approach to evaluate our real estate portfolio and address the underperformers, regardless of the economic environment. Over the long-term, this will raise the performance of the entire portfolio, as we close the underperforming stores that did not provide an opportunity to generate an attractive return. Capital will continue to be allocated to the brands with the best returns.

At April 30th, we had borrowings of $269 million under our line of credit; approximately $21 million lower than the prior year. We had $68 million in cash at quarter end, compared to $53 million last year. We believe we not only had the liquidity to weather the current environment, we had the strategic financial flexibility to capitalize on opportunities as they present themselves. We have a solid balance sheet and our credit facility is well-structured, favorably priced, and has a maturity of 2011. We will continue to emphasize free cash flow and putting uses of capital.

As I said earlier, one of our goals is to turn underproductive inventory into cash, which will create additional flexibility in positioning the business for 2009. As we focus on cash flow, it is important to note that inventory liquidation in fiscal '08, combined with capital expenditures reductions, should result in operating cash flow in the range of $85 to $95 million, excluding the $175 of net proceeds from the sale of Bailey Banks & Biddle.

With our focus on cash flow, we are pleased that lifetime warranty sales have continued to be solid, given the increase in clearance sales. Our sales team has continued to do a terrific job in terms of benefits of the warranty program. And as I mentioned earlier, deferred revenues will be recognized over a significantly reduced share count resulting in substantial EPS benefit.

Now for a few comments on the fourth quarter: Given the success in gaining market share during the third quarter, we would expect sales trends to continue though at a reduced rate. We also believe we can move through an additional $20 million in inventory, bringing the total clearance reductions to approximately $120 million. This will result in lower gross margins than expected or than experienced in the third quarter. And we still expect the third and fourth quarters combined to be impacted by approximately 500 basis points to 600 basis points, in line with our original expectations.

This additional clearance inventory reduction will provide us the flexibility to enhance our assortments, resulting in greater clarity of our offerings earlier than anticipated. We expect SG&A in absolute dollars to remain similar to the third quarter. We expect to achieve approximately $6 million from our operational efficiency program, which will bring the total for the year to $12 million. The remaining $53 million, plus in overall expense reductions will be in fiscal '09 to achieve the targeted $65 plus million in savings. The savings will be offset in the fourth quarter by variable expenses related to projected sales increases and our occupancy related costs.

Taxes will continue to be impacted by the relationship of taxable to nontaxable earnings, and our fourth quarter tax rate is likely to be approximately 50%.

As I discussed earlier, the share count for the quarter is approximately 35.5 million shares. It is also important to note that going forward, sales and earnings will be disclosed simultaneously on one press release. We feel that investors will benefit from the disclosure of the entire performance picture rather than disclosing sales and earnings separately. However, given the material contribution of the holiday period, we will continue to disclose sales results for the holiday on retail sales day in January.

In summary, we are committed to maintaining financial rigor and discipline, especially when it comes to inventory management, expense management and capital investments. This commitment, combined with our financial strength and flexibility, has positioned us to drive shareholder value for the long-term.

I'd now like to turn the call back to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Lorraine Maikis from Merrill Lynch. Your line is open, ma'am.

Lorraine Maikis - Merrill Lynch

Thank you. Good morning.

Neal Goldberg

Good morning.

Lorraine Maikis - Merrill Lynch

I just wanted to get a quick clarification on something you said about cash flow, $85 million to $95 million, is that free cash flow?

Neal Goldberg

Yes, it is.

Lorraine Maikis - Merrill Lynch

Okay. And then, just looking at you're upping your clearance levels from a 100 to 120, do you expect that to be a permanent reduction or do you expect to investment the incremental $20 million in new products?

Neal Goldberg

This is just to clarify that as we said we expect the additional 20, we will invest in mostly proprietary merchandise, bridal merchandise, diamond merchandises which we have articulated again as what we're going to be focused on.

Lorraine Maikis - Merrill Lynch

Okay. Can you comment on any new proprietary products or tests that you have been doing to try to grow the penetration of that type of offering?

Neal Goldberg

Well, in the future we'll add more color to it. But suffice to say is that I said in my comments that we had very robust testing during the Mother's Day period and are very pleased with many of the results of that. And we think strategically going forward, by having great, great products; really great quality, value prices; and combining that with the emotional experience we expect to be projecting with our marketing; we think we've got a combination that should serve us very well in the future.

Lorraine Maikis - Merrill Lynch

Okay. And finally, can you just give us a little detail of the training programs that you are using for the employees that are in these pilot stores? What type of costs are you spending on training these sales people, and how are you measuring the effectiveness?

Neal Goldberg

I think in our last call, we talked about having best-in-class stores that were outpacing the chain by slight double-digits, so almost 10%. That has continued, and as we look to the Pacesetters score what we have done is we have taken some of the knowledge that we’ve embedded particularly in authority with diamonds and with jewelry, and we have invested in those stores so that they can not only increase their confidence but be more articulate when they talk to the customer about those assortments. In terms of cost, the costs are not above what we've already built into our budget so it’s minimal.

Lorraine Maikis - Merrill Lynch

Thank you.

Neal Goldberg

Thank you.

Operator

Next question is from Janet Kloppenburg from JJK Research. Your line is open Ma’am.

Janet Kloppenburg - JJK Research

Hi Neal.

Neal Goldberg

Hi Janet. How are you?

Janet Kloppenburg - JJK Research

Hi, everybody. Hi, David, I wanted to ask a couple of questions, first on the sourcing side. I think you have said that you are increasing your proprietary product, but I also think you said that may be your lead times were moving longer. So, I wondered if that was correct. And what do you think about the risk exposure there? And secondly on the clearance program, do you expect to have the $120 million in clearance completed by the end of the fourth quarter?

Neal Goldberg

I will answer the second question first Janet. We expect the majority of clearance to be done through the fourth quarter. We will probably continue some clearance through August. And clearance will always be part of our assortment. I don’t view clearance as a bad thing.

Janet Kloppenburg - JJK Research

Right.

Neal Goldberg

But the majority of it will be the end of fourth quarter, potentially a little bleeding into the beginning of the first. On the lead time, let me clarify that. Understand, we view this lead time as not a bad thing; we view it as an exceptionally very good thing. We know our business is fairly predictable to a large level. If we can partner-up with our key vendors and work with them, we should be able to get better quality and better cost efficiencies by spreading out their manufacturing time over a longer period of time.

So, in fact, we think it will benefit us in a couple categories, quality as well as price and as well as strengthening our partnership with these individuals. So, we view that as very good as oppose to be getting orders last minute, rushing, not getting the best cost efficiencies as well as certainly suffering in the quality category.

Janet Kloppenburg - JJK Research

Okay, and on the pacesetters stores Neal, the 135 stores. Are those your best stores, your most affluent markets or your high sales per square foot stores? Can you give us a profile of those stores?

Neal Goldberg

It’s a mixed profile there. Our key strategic stores, they cross country, they cross market place types. There are many of our largest volume stores, many of them are highest contribution stores, but the mix again is roughly 20% of our sales and exceedingly more in contribution to the company. So, we really felt, it’s a great rate to run the business, to stay very focused, do a lot of wonderful things, and these stores take those learnings and then pass it out to the entire fleet.

Janet Kloppenburg - JJK Research

Right, I was just wondering if some of them represented different customer profiles than other stores in that 135, therefore the learnings could extend to different, to the A, B, and C stores as opposed to just the A stores.

Neal Goldberg

Yes, the answer is yes. It crosses over both countries. It crosses demographic, sociographics. It covers the entire North American continent and different types of stores, different size of stores, different category of malls. So, I believe the answer to your question is yes.

Janet Kloppenburg - JJK Research

And as you look forward with the success of your marketing program here for Mothers Day, what do you think about your marketing spend, Neal, now that you've been there a while. Will it remain at current levels, could it move higher, what is the direction of that spend?

Neal Goldberg

The first most important, we feel very strongly that we need to have our marketing to be much more emotional as that would be lead by product and supported by price. We really want to make sure that it resonates emotionally with our customers in our Mother's Day, Mom Rocks campaign. We are very pleased with the response to those who wanted it for sales as well as the comments and responses that we’ve received from all of our constituents.

From marketing spend, we are still going to look together as efficient as possible with our marketing. We spend, I believe too much inefficiently in the past, so the critical right now is we've said, we were ready to take a reduction in marketing spend, that said to support it. We believe we have opportunities to support more volume growth and more profit growth in the business, then we will spend it appropriately. But its not about how much you spend, it's how efficient that spend is and we think we’ve done some very good things with some different marketing spend tactics that we tested over the Mother's Day period that we are very pleased with.

Janet Kloppenburg - JJK Research

Okay and just lastly Neal, we hearing on a lot of calls, over the last couple of days, a lot of caution about how the May, June, July quarter has opened up. And it appears that there is a lot of caution on the part of the consumer perhaps inline with our gas prices are ticking up. Do you guys have any comments on that and what trends are you seeing?

Neal Goldberg

Clearly I can't comment on your macro economics, I just pay $4 plus the gallon gas my self. But that said, we were very, our third quarter results we are pleased with, we see that trend continuing through our Mothers Day results, we are very focused on getting through our clearance, getting a lot of great learning’s on new product and seeing the success of those, taken those learnings, making sure our stores are much compelling, making sure our assortments are easier for our value customer in a shop through, making sure our points are arrowed well.

So, we've taken all these learnings. We're very focused on the future. We're focused on what we are doing, whereas the team is locked on in our objectives, and the macroeconomics would be what they will be. Clearly no people are going to have anniversaries or birthdays, people are going to get married. We just want our unfair share of the jewelry market.

Janet Kloppenburg - JJK Research

Great. Good luck.

Operator

Next question is from Adrianne Shapira from Goldman Sachs. Your line is open ma'am.

Adrianne Shapira - Goldman Sachs

Neal, it sounds like the key focus here is you're talking about the focus on the value customer. But could you help us understand once you worked down the inventory for most of it through Q4? How do you plan to win that customer offer these extreme promotions? Specifically, what will the promotional cadence be, heading into the holiday and what will that look like year-over-year?

Neal Goldberg

Well, first of all, we were pleased and again what we said is we're exceeding our expectations on the clearance. We're also pleased that though the clearance mix up, it's much less than one may think it is, and we are getting great learnings on a lot of the new merchandise we have brought in from Mother's Day, and a lot of the testing which we took advantage of based on having the additional traffic.

Going forward, we very much believe that having a cleaner assortment, being very targeted on our product offerings, making sure that the customer, when they come into our store, can see the clear delineation between good, better, best, supporting with promotional marketing that should be much, much different than the past, which was only focused on price, and making sure we have the proper promotional cadence.

So, are we going to follow the same promotional calendar as last year, locked up? Absolutely not. Will we have promotional events during the future? Absolutely. So I think it's making sure it's targeted, making sure it's planned for mixed with a great product offering at a great value price.

Adrianne Shapira - Goldman Sachs

Okay. So is it just a simplifying for the customers' perspective heading into holiday, or do you think it's more or less promotional than last year?

Neal Goldberg

Right now, there is a lot of water to go under that bridge. We will see how the customers are doing back then, but right now I do not want to play an up and down game throughout next year. And we think by making sure that the offering is clear, it will give us a lot more opportunity to promote a lot smarter.

So what you will see? Again, right now what we are seeing to our Mother's Day is though the clearances selling, we are seeing a good mix in business, we are seeing a lot of new products sell that is not being promoted and we think a lot of that is due to, in some cases the clarity of offering that is, that we benefited from by having less good in our cases.

We think it's a little bit driven by a different compelling visual message in our store which was not in our stores in the previous and we can also tell you that our field is extremely enthusiastic and I'll take an enthusiastic field organization that sees the direction the company is going and they are more aggressively selling.

And so all that comes together and it looks pretty good to us. How the macroeconomics will be Adrianne? I can't tell you. We will certainly have to keep an eye on what's happening in trends. But again, we can only comment on what's happened in the third quarter and what we are seeing already happening in the fourth quarter through Mother's Day.

Adrianne Shapira - Goldman Sachs

Okay. Thanks, Neal. That's helpful. And in terms of your more cited field organization, can you give us any sense for us even in the pacesetters, or beyond any change in incentives, or compensation plan to get to maintain this enthusiasm?

Neal Goldberg

An enthusiasm comes from two things, and I don't want it to be just thought of it as incentive enthusiasm. I'm communicating to the field, listening to the field, responding to what the field has been, asking for, and getting them those responses. I believe it's really what's creating the great enthusiasm we are feeling right now, one.

Two, as I said in my comments, in the future we'll comment more in total on the pace of that program as we develop some of these things. So we'll talk to you about the scope of it from the in-store, from assortment, from what we're doing for the teams in those stores in the future.

Adrianne Shapira - Goldman Sachs

Okay. And then, you mentioned gas, and obviously we're seeing inflationary pressures, can you talk about how you're handling the inflationary pressures in your cost of goods, in terms of what is happening with the sourcing, are you probing it or are you having gone, hasn't been thinking about (inaudible)?

Neal Goldberg

I'm going to let Gill Hollander answer some of that. But I do want to comment on, again, by what we've done in our organization to get it more nimble, quick and agile, and to really be focused on being more plan full, getting and partnering up with our vendors earlier is providing us some cost efficiencies that one may not think about, because by giving orders last minute is not helpful. By giving them enough time to get the orders in will provide some cost efficiencies.

Gill Hollander

Bottom-line, the majority of the cost of our goods is in the diamonds, and most of what you hear about increases within the commodity of gold and silver, along with some issues we're having with the dollar. So while we have had some price changes, they've been selected and targeted, and where we have had some decline in unit sales, it's been offset by a higher ticket.

Adrianne Shapira - Goldman Sachs

Great, thank you.

Neal Goldberg

Thank you.

Operator

Our next question is from Bill Armstrong from C.L. King & Associates. Your line is open, sir.

Bill Armstrong - C.L. King & Associates

Good morning. When you said earlier that you expect trends to continue into the fourth quarter, should we take that as being same store sales in that 5% to 6% range?

Neal Goldberg

As a general direction, what we've said is that we expected those trends to continue which was regarding sales. There was little moderation on it with that guidance; it may slow a little bit. But, yes, general trends should be similar.

Bill Armstrong - C.L. King & Associates

Okay. How do you view the overall market? Obviously jewelry demand was very weak over the holidays; you're seeing some strong sales because of the liquidation. How do you see the underlying demand, and is there any improvement there, or is it still a pretty soft?

Neal Goldberg

Well, again, we can comment on our comp which is [six] comp for the third quarter. We could comment that yes, the clearance mix, people are coming into our stores, we are selling the clearance, and we've exceeded our expectations. That said, we had a lot of test products in our stores and we are seeing some very good sell-through on those. So, we are taking advantage of that increased traffic, as all the things were very focused on, making sure clarity, we often making sure we're listening to what our stores are telling us, that our customers are asking for better quality, that they are asking less specific things, they are asking for an assortment, making sure we are focused on that, making sure that we are responding to the customer and our stores needs, getting a more emotional message out there, than just price. We are very focused on products supported by price. We think all of those things will serve us well in the future. Macro economics again that’s more enough to figure what's going to happen in those.

Bill Armstrong - C.L. King & Associates

Okay, and then finally just housekeeping. Rodney, could you breakout the number of stores opened at the end of the quarter for five divisions?

Rodney Carter

As far as ending count?

Bill Armstrong - C.L. King & Associates

Yes.

Rodney Carter

Okay, the ending count, we had 786 Zale's, 261 Gordon's, 143 Outlets, 209 Peoples, and 739 kiosks for Piercing Pagoda.

Bill Armstrong - CL King & Associates

739, okay. And how many were opened and closed during the quarter?

Rodney Carter

There were 43 opened and 45 closed for the year. I don’t have the quarter number here handy. 10 openings and 37 closures, count in kiosks.

Bill Armstrong - CL King & Associates

10 and 37 as for the quarter?

Rodney Carter

Yes.

Bill Armstrong - CL King & Associates

Okay, great. Thanks.

Rodney Carter

Thanks.

Operator

Next question is from Jeff Stein from Soleil. Your line is open, sir.

Jeff Stein - Soleil Securities

Good morning guys, a couple of questions, first of all, can you tell us roughly what percent of your sales in the third quarter was clearance relative to the prior year?

Rodney Carter

The clearance approached 20% it did not in quite reach that, and we've typically run 10, 12 percentage points below that.

Jeff Stein - Soleil Securities

Okay, great. And wondering what your growth margin target would be for the holiday selling season this year? Obviously you are about five points away from where you been historically. Do you think you can get back there or are you going to target kind of settling for less?

Rodney Carter

Well, the only discussion we have talked about today is what we are talking about the back half. In the next call when in Q4 we talk about the year, we will be in a much better position really to talk about holiday.

Jeff Stein - Soleil Securities

Okay. Can you talk about the holiday price equation, for holiday and when I say that I mean in past years Zale was kind of flip-flop focusing on more the moderate customers and am going to, trying to get more dollars to the higher end customers. What type of customer are you focused on, primarily for the holiday season?

Neal Goldberg

For the Holiday season and for the whole year, and for years to come, we are focused on the value-oriented customers. The value-oriented customer has clearly told us, our stores have told us, they want quality. Quality means things that are made well, things that will hold up well with the good price to it. And by getting better quality and getting a better price - getting a better price doesn’t mean we will accept nor should our customers accept poor quality goods. So, we are very focused, and that’s why we did this sourcing split with merchandising, and that’s why we are going out front earlier with our vendor partner to make sure that they understand the quality we need, that we don’t compromise that. But it will always be clearly a value-oriented customer today, tomorrow, holiday, the next year, and the future.

Jeff Stein - Soleil Securities

Okay, and the final question Neal. Historically the company has talked about the growth in direct sourcing and the ability for that initiative to produce about 50 basis points annually of gross margin improvement, and I am wondering, are you still on that track and if that is still important to you as it was, by our management team?

Neal Goldberg

I can’t comment on prior, but I can tell you we are on that track. We believe in direct sourcing. We believe in making sure our sourcing team has the tools to either produce ourselves or to produce it with our vendor partners to make great product at great prices. So, if we can advantageously do with ourselves, we will take advantage of that. If we have a vendor partner who could do it in a more advantageous way, we'll take advantage of that too. So, it is not, we are focused on growing our direct business to such a level, it’s a more of what's best overall for the business, and we will always play with that mix. The end result is to get the best margin we can, the best quality and please our customers.

Jeff Stein - Soleil Securities

Do you still think that the overall strategy is worth, perhaps an incremental 50 basis points a year for the next couple of years, all things equal?

Neal Goldberg

Yes.

Jeff Stein - Soleil Securities

Okay, great. And then finally, I'm wondering on this focus store program, the pacesetter store program. If 135, are you capable of doing this year, in other words, is it a people constraint in terms of the ability to focus on x number of stores or are there other considerations?

Neal Goldberg

No, there is, we have got a great team and I am very pleased overall with the team in all parts of the organization. Focus is, but you got to define at some place, we chose these 135 stores because of that. One, they do it sales and there are even more considerable on contribution impact. We think we will get this right as we get learnings. We will roll this out to more stores.

But, we always need to have a focus group that let's you really understand what's happening and get successes. We have clearly got to roll that out to many, many more stores. Right now it's 135, and in the future we will always have a desk sell of stores and a group of stores to really learn from. But I guess, it does, I don't want anyone to leave thinking that that's all we are going do those 135, we're focused on the whole fleet, these 135 will get some great learnings and roll them out.

Jeff Stein - Soleil Securities

Got it, thank you.

Operator

Next question is from Brian Tunick from JPMorgan. Your line is open, sir.

Evren Kopelman - JPMorgan

Hi, it's Evren Kopelman for Brian. Good morning. My first question is on the competitive environment, if you can talk a little bit about these industry dynamics overall that you have seen? And secondly, maybe anecdotally from your stores, we know [Kay] when we took up prices and treatment is liquidating some of their stores. How your stores are getting impacted and general commentary on the competitive dynamics?

Neal Goldberg

Well, I guess, overall, as our comments indicated, we had almost 6% comp. We are very focused on making sure we are really addressing our value-oriented customer, making sure our assortments are much, much, clearer, making sure that where really the customer comes in can understand a good, better, best proposition.

Our stores enthusiasm, we're getting in our stores based on many of the recent things, we are doing both with the focus on our pacesetters stores. Overall, communication to our field organization has been very well-received. We do have selected price increases, but again, these are surgical price increases, we will take them as necessary.

The competitive environment, the jewelry business always has a lot of players in it. We're focused on what we are doing. And as I said earlier, we would love not to more than take a bigger share of the business as we demonstrated, we could in the third quarter.

Evren Kopelman - JPMorgan

But how do you think your price is compared to your competition, especially Kay today?

Neal Goldberg

I think we are very competitive. We are very pleased with the quality we are going to be offering and in many cases that we have today. As we've said, we are going to go after more proprietary goods. So we don't want just to become a price game. We believe it's about great assortments, great quality. It's lead by product and supported by price and some emotional purchases. Very little purchase that one makes is more emotional than a piece of jewelry. And giving someone a diamond is about better emotion of our quality, it's not always about just price. And that's what the proprietary goods will give us some advantage.

Evren Kopelman - JPMorgan

And finally, can you talk about your goals for long-term operating margins and when do you think you can reach it in the best case and in the worse case scenario?

Rodney Carter

This is Rodney again. I think similar to the gross margin question we'll be focused on giving more color on that. We're focusing on the trends. Obviously, we've talked about the $65 million plus of expenses that we're taking at a run rate. We want to focus on further enhancement as Neal alluded to in gross margin over time, gathering top-line, continuing penetration on warranty sales and we'll continue to grow new stores while continuing to close underperforming stores. I think it's too early to give a guidance of what that looks like, we are approaching on all categories, all buttons with the financial (inaudible).

Evren Kopelman - JPMorgan

A quick clarification, did you say for the first quarter you expect SG&A dollars to approximate Q3, so about $232 million?

Rodney Carter

Yes.

Evren Kopelman - JPMorgan

Great, thank you.

Operator

Our next question is from Chia Kuo from Telsey Advisory Group. Your line is open.

Neal Goldberg

Hello

Chia Kuo - Telsey Advisory Group

Hi, good morning. I was wondering if you could talk about the gross margin impact you expect in the first quarter of '09, given that the clearance activity could continue through the first quarter. And then secondly we are hearing from some of our real estate developers that there is more room for negotiating on rents, so you are seeing anything there?

Neal Goldberg

Well, I'm not going to really comment, actually we focused on the relationships that we have with our real estate developer partners on an ongoing basis, and so there is always trade-offs for the benefit of the ultimate partnership that we have between the two. I think relative to first quarter margins, Neal talked about being less promotional, therefore we would expect margins overall being higher. And at this time I think it will pretty mature to give too much color beyond that on margin expectations for quarter fiscal '09.

Operator

The next question is from David Mann from Johnson Rice. Your line is open, sir.

Neal Goldberg

Hello.

Rodney Carter

Hi, David.

David Mann - Johnson Rice

Hi. Good morning, Rodney. If you could go back and talk on the sourcing comment you made. Can you clarify what the new lead times might look like, given the vendor consolidation?

Rodney Carter

It's again a little varied, but what we really want to do is give our vendors as much lead time as we can, that will ensure that the quality is great, and that we're getting costing benefits from it. So, this is not a seismic shift, what this really is, I think, running the business in a much more efficient manner.

We know holidays are going to come. We have good ideas. Historically, even good years, bad years, since we know, in general, what the size of the business will be, we should be able to take advantage of that by giving our vendors orders earlier. That really was prevented maybe in the past by us not being as prepared, not doing as much robust testing and Mother's Day getting as much results. And it's disciplined by having a very tight calendar, running our business to that calendar that we can make sure we get that efficiency.

So it's not saying we're going to go from x weeks to x weeks. It's really looking by category, taking advantage of what we see as opportunity. If we don't get an advantageous quality and/or price benefit from it, then we won't do that with some people. But on the whole, being a partnership is a two-way street, and we want to make sure our vendor partners have enough time to get the products built right, assembled right, and that we get a good cost from it.

David Mann - Johnson Rice

So, for this coming holiday, when will the bulk of your orders be placed?

Neal Goldberg

Suffice to say, much earlier than they were last year. I'm not going to comment on the exact dates of it.

David Mann - Johnson Rice

Okay. In terms of the -- specifically on the bridal business, in this type of macro environment, can you just comment on what you're seeing, if any effect in terms of a slow down in the bridal business?

Neal Goldberg

We have not seen a slowdown. Actually, we're pleased with what's happened to the bridal business. We think we have a huge amount of opportunity to even grow more. People are getting married, so I don’t think – I have not heard, seen any statistics that say with a down economy that people get married less. So we have good and bad economies, and people are getting married. We want to have diamond dominance to make sure they come into our stores to make a purchase.

David Mann - Johnson Rice

Very good, and then in terms of some of the changes that you are implementing throughout the organization, has there been any amount of turnover that you needed to take at the store manager level?

Neal Goldberg

We will continue, and with William Acevedo joining the team, we are going through a lot of robust assessment of our store count. I am pleased to say, we've got a great store organization, we've got store managers, we've got many million dollars sellers and our associates. So, we are very pleased with the stores organization. Like any organization, we are constantly always assessing your talent. You are always working on raising the bar, we believe we have an opportunity to raise the bar to make our customer service experience a lot better, and that is not just on the store delivery, that's having the right product and the right presentation that’s making sure the marketing is as compelling as possible, and having a fabulous store team to make they deliver it, that they can have the time to spend on the customer, not on doing tests. So William is leading that and we will continually asses the talent we have in stores. We know, there is an opportunity, but we also very pleased with the dedication of our store teams.

David Mann - Johnson Rice

And then, one last question. I think Rodney, in the past you've talked about or at least given an update on what the credit granting situation looks like. Can you just give an update on approval rates and penetration there?

Rodney Carter

Certainly approval rates are very similar to what they have been, they are relatively unchanged. I think the backdrop of the portfolio, according to Citibank, is facing similar types of characteristics as other portfolios. There is a little bit of softness. There is no financial risk that we have on that other than just exposure generally to consumer’s capacity to spend.

David Mann - Johnson Rice

Great, thank you very much.

Neal Goldberg

Thank you.

Operator

Yes sir. At this time we have no further questions in queue.

Neal Goldberg

Okay. Thank you to all of our associates, shareholders, and vendors for their continued support. Have a great day. Thank you all.

Operator

This concludes today’s Zale Corporation third quarter 2008 earnings call. You may now disconnect.

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Source: Zale Corporation F3Q08 (Qtr End 04/30/08) Earnings Call Transcript
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