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Zale Corporation (NYSE:ZLC)

Q4 2008 Earnings Call

August 28, 2008 9:00 am ET

Executives

David Sternblitz - VP & Treasurer

Neal Goldberg - President & CEO

Rodney Carter - EVP, CAO & CFO

Analysts

Lorraine Maikis - Merrill Lynch

Bill Armstrong – CL King & Associates

Brian Tunick – JP Morgan

Janet Kloppenburg - JJK Research

Jeff Stein - Soleil Securities

David Mann - Johnson Rice

Operator

Good morning, I would like to welcome everyone to the Zale Corporation fourth quarter and full year 2008 earnings conference call. (Operator Instructions) I'd now like to turn today’s call over to Mr. Sternblitz, Vice President and Treasurer; please go ahead sir.

David Sternblitz

Good morning and thank you for joining us for our fourth quarter and full year 2008 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, Chief Executive Officer; Rodney Carter, Executive Vice President, Chief Administrative and Chief Financial Officer; Theo Killion, President; Gil Hollander, Executive Vice President and Chief Sourcing and Supply Chain Officer and Cindy Gordon, Senior Vice President, Corporate Controller.

Before we begin, I'd like to review the Safe Harbor. Our commentary and responses to your questions on this conference call will contain forward-looking statements, including statements relating to our future goals, plans, and objectives.

These forward-looking statements are not guarantees of future performance and a variety of factors could cause our actual results to differ materially from the anticipated or expected results expressed in these forward-looking statements.

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 April 30, 2008.

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

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

Neal Goldberg

Thank you very much David. Today I would like to briefly discuss the fourth quarter as well as accomplishments against our plans, and then I will spend some time on how these achievements position us for the new fiscal year.

First the quarter, we sustained the strong momentum from Q3 into Mother’s Day and throughout the period. We again captured market share with our second straight quarter of 6% comp increases. This demonstrates our continued ability to drive traffic and acquire new customers in a tough environment.

For the quarter we exceeded our own expectations for sales, earnings and inventory reduction. EPS after adjustments for a change to our vacation policy and the sale of a non-core asset was a loss of $0.48 for the quarter.

This loss was impacted by the additional 3.9 million shares we repurchased during the quarter. After a challenging start to fiscal 2008, which included a disappointing holiday season, we had a focused agenda with clear objectives for the back half of the fiscal year.

I am pleased to report that we exceeded these objectives. Our plan centers on leveraging Zale’s strength as the major value player in the jewelry industry. The plan consists of three parts; one, reengaging our core customer, two enhancing operational effectiveness and three, maintaining financial rigor.

The focus on our core customer centers on merchandise, marketing and the establishment of our pacesetter stores. Step one was a strategy targeted at a $100 million reduction in inventory. We successfully exceeded by target by profitably clearing $127 million of inventory by July 31. This planned $100 million permanent reduction along with a 40% reduction in SKUs is critical in creating a cleaner statement in our cases making it easier for our customers to shop.

The success of the clearance strategy also allows us to reposition our assortment that much faster with additional investment. The new product will further highlight the good, better, best differentiation with less inventory cluttering the cases.

Importantly we used the strong customer traffic to test new goods and gain key learnings. We had great sell-through on a number of items that we brought back into for the upcoming holiday season.

Aside from injecting newness into the assortment, quality is of equal importance and has been improved across all categories. We believe this will be evident as our fall receipts begin to hit the stores. I will discuss our quality initiatives in more detail as part of our new sourcing organization’s responsibilities in a moment.

In addition to merchandise improvements by marketing more affectively to our customers we have simplified our message and brought emotion back to our campaigns. Product now leads our offering supported by price.

This approach has been integrated across multiple touch points of the customer experience. The in-store merchandise presentation is cleaner and much more compelling. Signage has also been greatly reduced to provide greater clarity of message.

We designed marketing campaigns that elevate emotion and resonate more strongly with our customer. Our Mom Rocks campaign for Mother’s Day for example, was very favorably received by all of our key constituents and represented a good start as we work to cut through in the marketplace.

Our direct marketing and catalogues reflect our brand positioning, tie into the emotion of jewelry and are more focused with less items per page. As with our in-store merchandise, product is the hero.

In our last call I mentioned our pacesetter store program. As you will recall these 135 stores represent 7% of the fleet, 20% of the volume and even more of the profits. We are [distorting] time, resources and product in these stores as we use them as laboratories for the chain.

While we have significantly increased the level of communication in both directions for all of our stores, this is especially true for our pacesetters. Each member of our senior management team has been given a responsibility for a group of these stores. Their role is to sponsor and support the pacesetters.

Besides enhancements being made such as LED lighting and new carpet, we’ve also increased the diamond and customer service education for our associates in these stores. By developing our people into experts, they are better positioned to take advantage of a diamond assortment, 40% greater then the balance of the chain.

We expect 90% of the pacesetter stores to be finished with our planned investment and fully set for holiday by mid October. We recently invited all of our pacesetter store managers along with field management and top jewelry consultants for meetings here in Texas. We provided clarity on our holiday strategy and how to execute against those strategies.

There is enhanced level of training for district and store managers and we also celebrated the achievement of many of our top jewelry consultants. The level of commitment throughout the company was critical to make this meeting a success as we continued to invert the pyramid and synergize our field and support organizations.

Our second goal is enhancing operation effectiveness; we have a well rounded and cohesive management team comprised of veteran executives as well as additional new talent with significant retail experience.

With Theo Killion becoming President of our company I am confident we have the leadership not only to continue to develop our go forward strategy, but to execute it. We have taken steps to build a stronger leaner organization better equipped to focus on our core customer. The new structure eliminated the brand silos and numerous redundancies.

These changes are helping us to connect better with both our associates and our customers along with increasing communication and cooperation across brands.

Within this new organizational structure we have strengthened the distinct roles of our merchandising and sourcing organizations. Our merchants are focused on building the right assortment, studying our business and evaluating the competition.

The team is now being led by Mary Kwan, our new Chief Merchandising Officer. She will be instrumental in developing more compelling assortments that highlight our good, better, best value proposition ensuring that we are connecting with our core customer.

Our corporate sourcing group, led by Gil Hollander, with 35 plus years of jewelry and sourcing experience is procuring merchandise and partnering with the best vendors who are focused on best quality, best costs, best delivery.

We have reduced our vendor base by two-thirds since the beginning of this process. By partnering with select vendors we are giving them more timely purchase orders, with longer lead times, further supporting our initiative to receive better quality product and improved cost efficiencies.

The new structure also supports our initiative to improve quality. As our sourcing organization developed a range of specific standards that are enforced company wide. We then communicated our expectations to our QA teams in India, Asia and Canada as well as visited with all our diamond vendors to make sure everyone is on the same page.

To ensure our new standards are being met our QA team is carrying out inspections earlier in the process. This involves doing pre-inspections in factories as well as monitoring the production process.

We have created a vendor and product development arm that guarantees nothing new is purchased without verifying the integrity of the product. This group is not comprised of merchants, but people with strong technical knowledge in manufacturing and design.

Finally our vendor scorecard incorporates damages into the assessment to ensure we are partnering with suppliers that provide high quality products that meet our standards making it a profitable relationship for both parties.

We have also realigned our field organization under the leadership of William Acevedo, our Chief Stores Officer, to further increase our effectiveness. Significant time has been spent identifying the right talent and developing changes to our compensation system that rewards accountability and productivity.

We have a tremendous core of capable and knowledgeable associates that are our most valuable asset. We recognize that long-term success requires having the right individuals in every position across our organization and our ability to attract, develop and retain the smartest and most motivated people is essential to a business built on relationships.

Our stores are the frontline to deliver the customer experience. The feedback they receive from customers is absolutely critical for the service to be first class. We are reconnecting with our stores, listening to their input on how we can better serve them and ultimately our customers.

The entire management team has spent a significant amount of time in the field, listening and identifying areas we need to improve. This will be ongoing. To truly be a customer centered organization you have to develop a culture that lives in the stores. The answers are there. You just have to spend the time; we have and we will continue to do so.

We respect our stores so much that we recently changed the name of our corporate headquarters to Store Support Center. Words matter and since almost our entire revenue is generated out in the field we wanted this to be reflected in our office name.

We recognize the importance of a strong stores organization to our success. Under pinning our new strategic initiatives is our continued commitment to financial rigor and discipline. Specific actions we took included as I mentioned earlier, the liquidation of $127 million of clearance inventory, $100 million of which was permanently reduced.

As part of our effort to eliminate redundancies and create a more streamlined organization we announced in February 2008 that we had identified $65 million plus in ongoing annualized savings. As part of our financial rigor we will continue to open and close stores based on return on capital.

It is important to point out that our net jewelry stores only decreased by five locations this past year with most of the net closures being Pagoda kiosks. In many cases the Pagoda closures were second or third locations within the mall with the closures improving productivity of the remaining locations.

We want to expand our franchise and we will but our growth will be balanced with ensuring proper returns are being achieved. Over the course of fiscal year 2008 we freed up a significant amount of capital. This provided us with a low risk opportunity to reward our long-term shareholders repurchasing $327 million of stock or 17.6 million shares which equates to 36% of our outstanding stock.

Finally we completed the sale of Bailey Banks & Biddle as part of our emphasis on achieving a higher return on capital as we focus on our core value oriented customer.

So as we finish the fiscal year, I am pleased with our response after a disappointing holiday. We will continue to focus on the execution of our strategy as we enter the new year.

Our customer will see significant amounts of new and exciting merchandise this year as we take product leadership to another level. We will have over 2,000 new items company wide this fall; more then double the prior year across many different categories.

A large percentage of this investment is in diamonds including the national launch of our proprietary diamond Celebration. We are focused on increasing our private brands and being the best in diamonds and this fall we will make a statement with Celebration, both with respect to our visual presentation of the product and in the breadth of our assortment.

The assortment will vary by store with our pacesetters having the full presentation of 50 Celebration SKUs. The cornerstone of our business will continue to be diamond and within that Celebration will represent the best of the best.

Additional investment is in diamond fashion categories as well as in a narrow assortment of fresh fashion product that we expect to turn multiple times during the year and drive increased traffic into our stores.

Given the significant inventory reduction we will have a compelling assortment as we do more with less. For example, we had 85 SKUs of diamond studs last year, reduced to 46 SKUs this year; a 46% reduction. This demonstrates just how over assorted we were in a basic diamond fashion category. With 46 SKUs today we can still provide a tremendous selection with a much cleaner statement in our cases.

Additionally by narrowing the SKUs we will have greater depth of product in our DC allowing for faster replenishment and improved in-stock position. Having met our near-term objectives we will phase out our aggressive clearance stance during Q1 as we set the stores with our new fall merchandise.

However, clearance going forward will not be a bad word and will be a part of an ongoing strategy to keep our assortments fresh. We would expect clearance to be between 6% to 8% or a mix at normalized levels going forward as opposed to the 4% to 5% it was previously.

Newness, especially in the fashion categories is critical to drive increased traffic and improved inventory productivity. This is a significant opportunity going forward with a new Chief Merchandising Officer to help us establish fashion relevancy and increase urgency with our valued customers.

As we strengthen the relationship with our value customer another advantage we have especially in this environment is the refocus on our proprietary credit. The Zale’s business was built on making fine jewelry affordable utilizing private label credit where necessary. It has not been an area of emphasis during the last several years.

As a reminder we outsource our credit to Citi, so Citi takes the risk and is contractually bound to certain approval criteria. Our stores are reengaging credit with credit applications up and approvals holding steady.

We see opportunity to partner with Citi and grow our credit mix for the new fiscal year with a continued refocus. As we look to the future we are excited about our opportunities. We have three major internal vehicles for growth that provide an attractive return on investment.

First, our Canadian brands have performed very strong with another double-digit comp increase in Q4. We have a dominant position in Canada and see even more market share opportunities through a new assortment as well as additional store growth.

The benefit of a diversified portfolio of brands is we can grow our Canadian store base where we are achieving much higher returns on capital and the economy is much healthier then we currently find in the US. We have opened 36 new stores in the last two years in Canada, giving us a total of 208 stores and we still have significant opportunity for growth.

Second, our ecommerce business continues to expand reaching $55 million in revenue this year. This includes a nearly 50% sales increase for the quarter and over 30% for the full year. Investments that have increased traffic and conversion rates include creative changes to the site and enhanced functionality, increased marketing as well as expanded assortment.

We have acquired more than 215,000 new customers online in fiscal year 2008, a 48% increase over the prior year. The online business has a potential to grow [expedientially] and meaningfully impact the bottom line. We have already seen revenues double in two years and triple over the last three years.

We strongly believe there is an opportunity to layer on additional growth by expanding our assortment to higher quality, larger stones with different shapes and cuts then we currently carry in our stores. Value can be at any price point and this is a natural extension of the ecommerce business that leverages our scale, supplier relationships, web traffic and services such as credit.

In fact vendors have been very eager to partner on this new opportunity. Our stronger online presence should have an even greater impact offline as we drive more traffic to the brick and mortar stores.

Third, Piercing Pagoda is starting to see improved results with comp store increases in the high single-digits for Q4. Performance has benefited from new investment in better quality diamond assortments and men’s categories such as steel. This investment was made possible through clearance of a significant amount of inventory over the last year.

Additionally we took selective price increases in fiscal 2008 to reflect increases in commodity costs as well as capitalize on the environment which has seen a reduction in competition. Furthermore we are starting to see the benefit from our real estate strategy at Pagoda. We have had a net reduction of 100 kiosks over the last five years. As I mentioned earlier, many of these closures had multiple locations in the same mall resulting in increased productivity of the existing store base.

These three growth opportunities are points of differentiation and are unique levers we can pull to grow our business. Finally our pacesetter stores represent a significant opportunity to generate increased sales and earnings. These 135 stores were selected due to their potential to drive the most meaningful contribution.

Our goal is to have the best people, product and presentation to drive the best performance in a focused group of stores. We will migrate these learnings from these stores to the remainder of the chain.

With our strategies in place execution will be key. To improve execution we have stressed being more planful in all areas. Working from a detailed integrated merchandise calendar, 100% of our holiday orders have already been placed and should be received significantly earlier then prior year.

Our stores will begin receiving new fall merchandise starting in September. Their customer will see significant amounts of new and distinctive products and just as important, the significant reduction in SKUs should improve our in-stock positions especially during the critical holiday season.

We understand our sweet spot is value which is a great place to be in the current environment. Our marketing and promotional calendar is set and we will continue to be very aggressive at the key events and holidays when traffic and opportunities are there.

Outside of those planned events our marketing campaigns will continue revolving to connect emotionally with the customer, leading with product, supported by price. Additionally to improve our ROI we have diversified our marketing spend becoming more targeted in both the mediums we use and demographics we are reaching.

We will have a very balanced approach to our pricing structure. We have surgically taken some price increases along with some decreases. We will have strategic clearance which will represent a larger percentage then we have had historically to keep fresh product in front of our customer.

We expect to recapture a majority of the gross margin dollars we lost last year due to the clearance strategy but recognize that the external environment could impact this to some degree. From a financial standpoint we will continue to be disciplined focused both on the generation of free cash flow and the identification of efficiencies in our business.

Our guidance for fiscal year 2009 is adjusted EPS that includes total warranty sales is expected to be in the range of $2.35 to $2.50; an increase over prior year of 93% at the mid point of our guidance. This will be based on comp store sales in the range of negative 1% to flat. Free cash flow for fiscal year 2009 should be in the range of $145 million to $155 million, which is very significant on a per share basis given the large amount of stock we have repurchased.

We feel this guidance is realistic and incorporates the current macroeconomic environment. It is simple math as I call it, that even with a flattish same store sales we receive the benefit from a number of our initiatives such as the $65 million reduction in expense, $100 million permanent decrease in inventory, 36% decrease in outstanding shares, $40 million reduction in capital expenditures, and a real estate strategy based on return on capital.

Our expected GAAP earnings of $1.10 to $1.25 per share continue to be impacted by the change to our accounting method for lifetime jewelry protection plans. Even with flat sales earnings growth will continue to accelerate as the company recognizes incremental revenue each year.

In closing, while financial performance for the year was not up to our expectations laying this foundation was critical for us to provide consistent top and bottom line growth in the future. Having reached our initial objectives we are committed to taking the next steps in the execution of our plan to improve performance.

There are numerous opportunities for us to capitalize on. We have the best name in jewelry. In fact a recent JCK Harrison Group consumer jewelry study found Zale as the most recognized jewelry brand. With Zale ranking first in [unaided] brand recall it underscores the potential we have in front of us.

Now I would like to ask Rodney to review the fourth quarter and full year performance and provide further financial details.

Rodney Carter

Thank you Neal and good morning everyone. My comments will elaborate on the financial results of the fourth quarter, our fiscal year ended July 31, and the projected financial impact of our strategies.

As previously discussed the sale of the Bailey Banks & Biddle business was concluded on November 9, 2007 and the brand’s performance has been isolated and reported as discontinued operations on the face of the P&L for the quarters and years ended July 31, 2008 and 2007 respectively.

The balance sheet information as of July 31, 2007 has not been restated to exclude the Bailey Banks & Biddle assets. The following are the key statistics for the fourth quarter of fiscal 2008.

Comparable store sales increased 6.1% which follows a 5.8% third quarter increase. Our clearance strategy represented approximately 20% of sales and drove increased traffic across the entire assortment. These results compare to flat comparable store sales in the fourth quarter of 2007.

Total revenues in Q4 were $456 million compared to $430 million last year, an increase of 6.1%. The average transaction was down slightly at $166 compared to $172 last year. The customer continues to respond favorably to our lifetime warranty product and total sales of warranty products increased to $26.2 million compared to $24.7 million in the fourth quarter of 2007.

We anniversaried the rollout of the lifetime warranty product in the fourth quarter and revenues recognized increased to $11.1 million in 2008 versus $9.2 million in 2007.

As we have previously discussed last year we extended the service period for the warranty plan offered to our customers from two years to the lifetime of product ownership while simultaneously raising the retail price. As the product accounting continues to normalize over the next three to four years, revenues recognized will more closely reflect actual sales.

As a result we believe the difference or the change in unrecognized revenue is a critical component to understanding the business and should be included when evaluating current results and earnings potential.

Given the nature of services covered such as ring sizing, we anticipate the expenses associated with servicing the warranty contracts will largely be incurred within a few months of the original sale. In other words, the expenses are incurred and reported close to the time of sale, while the associated revenue are recognized over several years.

The increase in unrecognized revenues or warranty sales adjustment for the fourth quarter is $15 million before taxes or $9.2 million after-tax and $0.27 per share. Accordingly the net change in unrecognized revenues represents both the incremental cash and the potential positive impact on future earnings.

Gross margin for the quarter was 47.3% of sales versus 53% last year, a reduction of 570 basis points in line with expectations. SG&A excluding the cost of insurance operations was 47.2% for the fourth quarter versus 50.6% last year as a percentage of revenue.

SG&A includes a $12.6 million benefit from the release of a vacation accrual; of the benefit $11 million represents an accounting change in the liability and not an ongoing save. However, $1.5 million is an ongoing cash save which was identified as part of our expense reduction initiative.

Excluding this gain SG&A as a percentage of revenue was 50%. The remaining decrease is a result of a $6.4 million savings from the $65 million expense reduction initiative. Operating loss for the quarter was $16.4 million, compared to a loss of $6.1 million last year.

This loss includes the gain of $12.6 million related to the change in vacation policy. Excluding this gain operating loss for the quarter was $29 million. Other income is a $3.5 million gain on the sale of an unproductive asset which generated additional cash for reinvestment.

The effective tax rate for the quarter was 68.8% versus over 100% last year. The 2008 fourth quarter effective tax rate reflects the cumulative impact of adjustments to the annual effective rate. The fiscal 2007 effective tax rate includes an $8.5 million benefit associated with our APB 23 election to permanently reinvest the earnings outside the US.

Net loss for the fourth quarter from continuing operations was $4.9 million or a loss of $0.15 per share. The 2008 results include the combined after-tax gain of $11.2 million or approximately $0.33 per diluted share from the release of a vacation accrual and the sale of a non-core asset.

Net income from continuing operations for the fourth quarter of 2007 was $700,000 or $0.01 in earnings per diluted share. The 2007 results include a benefit from the election of APB 23 of $0.14 in diluted EPS.

The net loss for the fourth quarter of 2008 was negatively impacted by a reduction of the shares outstanding. Weighted average shares outstanding were 33.6 million in the fourth quarter of fiscal 2008 versus 49.2 million in the fourth quarter of fiscal 20074.

As adjusted for the after-tax gain of $11.2 million the net loss for the quarter would have been $0.48 per share. Before I talk about our strategic progress I’ll make a few comments on the fiscal year.

Including a disappointing holiday comparable store sales were down 5.1% for the six months ended January 31, 2008. Our second half sales results improved and we concluded the year with comparable store sales relatively flat or down 0.7%.

By brand our results for the full fiscal year were: Zales and Gordon’s down 4.8%; Peoples up 16.9%; Pagoda down 1.1%; Outlet down 2.7%; and our dot com business up 32.2%.

Total warranty sales were $121 million compared to $108 million last year. The attachment rate was 51% which demonstrates the continued value perceived by the customer. Recognized revenues were $41.6 million compared to the $45.1 million last year. Recognized revenues of $41.6 million were $79 million less then the actual warranty sales.

The resulting change in unrecognized revenues of $79 million is expected to flow through earnings essentially at full margin. This $79 million increase in unrecognized revenue on a normalized tax rate of 39% equates to $1.14 in earnings per diluted share.

We believe this adjustment for actual warranty sales is critical when evaluating the total results of the business.

The clearance strategy impacted gross margins as anticipated by 322 basis points as we concluded the year at 49% versus last year of 52.2% of revenues. Operating earnings from continuing operations including a $12.6 million benefit from the release of a vacation accrual were $11.7 million versus $84.9 million last year.

Excluding this gain operating loss from continuing operations was $900,000. The effective tax rate for the year was a benefit of 29.6% compared to an expense of 27% in fiscal 2007. The 2008 benefit was driven by the relative amount of the loss in our US business as compared to earnings in our Canadian entities. The 2007 tax rate was driven by the election of APB 23 in the fourth quarter of fiscal 2007.

Net income for the year including the sale of Bailey Banks & Biddle, the vacation adjustment and gain on the sale of an asset was $10.8 million or $0.25 per diluted share compared to $59.3 million or $1.21 per diluted share last year. Net income from continuing operations was $3.7 million or $0.09 per diluted share compared to $48.1 million or $0.98 per diluted share last year.

Excluding the after-tax benefit from the release of a vacation accrual and asset sale gains of $11.2 million the net loss from continuing operations was $7.5 million or $0.18 per share. As I discussed earlier, the net increase in unrecognized revenues of $79 million before taxes equates to $1.14 per share in additional earnings or net earnings per share adjusted for total warranty sales of $0.96.

We ended the year with 2,135 locations consisting of 1.396 stores and 739 kiosks. We continue to balance opportunistically opening or renovating locations as well as closing underperforming stores. We closed 48 stores in fiscal 2008 while opening 43 for a net reduction of five. In addition we closed 58 kiosks and opened four. Store and kiosk closures were based upon a commitment to provide long-term shareholders value not on any liquidity constraints. Many of our kiosk closures were in malls where we had multiple locations. By closing one we were able to consolidate business and improve productivity of the remaining kiosks.

The strong emphasis on enhancing shareholder value was evidenced by our share repurchase program this year. In fiscal 2008 we repurchased 36% of our shares outstanding for a total of $327 million at an average price of $18.59 thereby returning significant value to shareholders.

During the fourth quarter we repurchased $80.4 million or 3.9 million shares. These share repurchases are expected to be highly accretive over the coming years. We exceeded our internal expectations of $100 million inventory reduction and liquidated $127 million of excess inventory with a favorable impact on cash flow.

Merchandise inventory at July 31, 2008 was $780 million versus $1.02 billion last year, a decrease of approximately $240 million. Prior year inventory includes approximately $153 million related to Bailey Banks & Biddle.

Excluding Bailey Banks & Biddle inventory was down approximately $87 million which is a result of the clearance initiative offset by earlier receipts of new inventory investments. Inventory turnover on a rolling 12 month basis was higher at 1.21x this year versus 1.15x last year.

We have a solid balance sheet, our credit facility is well structured, favorably priced and has the maturity of 2011. We will continue to emphasize free cash flow and prudent uses of capital. We will continue to take a consistent approach to evaluating our real estate portfolio and address opportunities for growth as well as the underperformers regardless of the economic environment.

Capital will continue to be allocated to brands with the best returns. Over the long-term this will raise the performance of the entire portfolio as we close the underperforming stores that do not provide an opportunity to generate an attractive return.

At July 31 we had borrowings of $326 million under of line of credit compared to $227 million last year. We had $66 million in cash at the quarter end compared to $38 million last year. Free cash flow for the year was approximately $52 million. This is below our prior expectation due to the timing differences of approximately $40 million related to a tax refund which was received in August and earlier receipt of fall merchandise.

These timing issues will favorably impact fiscal 2009. We believe we not only have the liquidity to weather the current environment, we have the strategy financial flexibility to capitalize on opportunities as they present themselves.

As Neal mentioned we are focusing our attention on the value of our private label credit program. It has not been an area of emphasis during the last several years and has declined into the mid 30s as a percentage of our overall mix. These credit customers are on average more loyal and spend significantly more per purchase.

As a reminder we outsource our credit to Citi so Citi takes the risk and is contractually bound to certain approval criteria.

Now a financial overview of 2009, we have planned comparable store sales flat to down 1% for the year. We have planned the fall to be slightly ahead of last year at 1% to 2% comparable store sales as we phase out our aggressive clearance strategy in the first quarter and anniversary our negative results from the last fall of down 5% which included holiday sales results of down 9%.

In the spring we have planned sales down as we match off against the strong traffic that was enhanced by the clearance strategy. While clearance will continue to be an ongoing part of the business and as we focus on improving inventory productivity, we plan to move away from our more aggressive clearance strategy in conjunction with the arrival of new products as we move into the holiday quarter.

As we transition we expect to return to historical margins of approximately 51% to 52%. In February we announced our operational efficiency program and the plan to generate $65 million plus in annualized savings primarily in SG&A expenses. As we stated earlier, $10.5 million was realized in the third and fourth quarters of fiscal 2008, the remaining $55 million will be recognized primarily in SG&A reductions in fiscal 2009.

With these savings combined with targeted investments in store maintenance and identified inflation impacted expenses such as rent and store payroll, we anticipate SG&A to be approximately 45% as a percent of sales.

The effective tax rate is projected to be between 38% and 39%. Our store count is planned slightly down consistent with reduced capital spending in fiscal 2009 and continued prudent evaluation of stores at lease maturity.

Though store count is expected to decline in 2009 we have resources available to take advantage of attractive new store opportunities. Free cash flow is expected to exceed $145 million in fiscal 2009 as we benefit from higher earnings, flat to slightly lower inventory levels, reduced capital spending and the timing issues previously discussed from 2008.

GAAP earnings will be favorably impacted over the next four years as a cumulative impact of the unrecognized revenue begins to flow through net income. The adjusted net income for actual warranty sales normalizes earnings on a year-over-year basis from the impact of the accounting change.

And as we have stated the increase in unrecognized revenues is an important element and we believe more indicative of our actual performance. The projected increase in fiscal 2009 is $65 million before taxes or $1.25 per share after-tax. Including the change in unrecognized revenues, earnings per share are projected to be $2.35 per share to $2.50 per share in fiscal 2009.

We have provided the amounts on the press release issued this morning and end notes to our audited financial statements. We are projecting GAAP earnings per diluted share of $1.10 to $1.25 per share for fiscal 2009. We will continue to discuss earnings as adjusted for actual warranty sales and to GAAP earnings going forward which we believe will provide investors with great insight into the ongoing earnings performance of our business.

As I discussed earlier the share count going into fiscal 2009 is approximately 32 million with 23 million remaining under our share repurchase program.

In summary we are committed to maintaining financial rigor and discipline throughout the company. This commitment combined with our financial strength and flexibility has us positioned to drive shareholder value for the long-term.

We are now ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Lorraine Maikis - Merrill Lynch

Lorraine Maikis - Merrill Lynch

Could you just discuss the ongoing free cash flow potential of the company, I know there’s a $40 million timing difference but would you consider the remaining $100 million in free cash flow as an ongoing number that we should use and also can you comment on what you view as the best use of that cash?

Rodney Carter

On free cash flow, yes I do believe $100 or $100 million plus is a good run rate taking out the timing equation and we’ll look at all opportunities to return value to shareholders on the excess or the use of the free cash flow. I think at this point in time having a little extra liquidity going into this year in this environment is also not a bad thing.

Lorraine Maikis - Merrill Lynch

As you look at the competitive environment with a couple of bankruptcies there should be a lot more clearance in the market this holiday season, how do you think that affects your strategy of trying to move away from clearance?

Neal Goldberg

I think as we’ve said before we’ve experienced people going out of business before and liquidation, our business pre Mother’s Day was strong. We are very excited about the offerings that our customers will see with the amount of newness we have, with the presentation, with the differentiation of product. We think with just a great compelling assortment our associates are very pumped up with what they’re seeing. We feel we will fair very strongly and I’ve said before, all we want is our unfair share of the fine jewelry business that will be out there.

Operator

Your next question comes from the line of Bill Armstrong – CL King & Associates

Bill Armstrong – CL King & Associates

When does the deferred revenue start to become a neutral factor in reported earnings?

Rodney Carter

It’ll fully be neutralized in four years. After that any change in deferred revenues is just more like the change in comps. So it would be normalized out in full in four years.

Bill Armstrong – CL King & Associates

Four years from now, so fiscal 2013.

Rodney Carter

Yes.

Bill Armstrong – CL King & Associates

Average shares we should be using 32 million for this year?

David Sternblitz

That is correct.

Bill Armstrong – CL King & Associates

The $65 million in savings, did I hear you say that you realized about $10 million in fiscal 2008 and we’ll see the remaining $55 million in 2009?

Rodney Carter

Yes, $10.5 million or so was recognized on a run rate basis in the spring of 2008, the remainder will be recognized this year. Some of that is in SG&A remember and some of that is also, there’s certain expenses that would be reflected in margin and in interest expense that combine that.

Neal Goldberg

We are also very committed to continue our operational efficiencies and our financial rigor and we clearly said $65 million plus is our goal.

Bill Armstrong – CL King & Associates

The vacation accrual adjustment, it was $12.6 million; I thought I heard you mention there was a piece in there, was it $1.5 million that would be an ongoing benefit?

Rodney Carter

That’s correct. We will be granting in the year vacation is paid, which is the difference. The change would be any; no vacation would be paid upon separation for unused vacation. That’s an ongoing cash save and earnings save thereafter.

Bill Armstrong – CL King & Associates

The liquidations, you cleared $127 million, so we’re done now right? There’s nothing left other then the normal liquidation that you would have on an ongoing basis?

Neal Goldberg

As we said, we’re finishing up through this month but clearance is not a bad thing to us so we see on a normalized rate 6% to 8% of clearance as we continue to make sure we have freshness and newness so our customers come in and see some exciting new product. So clearance is not a bad word but the major liquidation of clearance strategy is ending.

Bill Armstrong – CL King & Associates

For fall you’re looking for positive 1% to 2% comps, in this environment that all sounds aggressive.

Neal Goldberg

Well if you look first of all what we are up against from first and second quarter of last year number one. Number two, we are very pleased with how our assortments look, they look very compelling. We have a large amount of newness, over 2,000 new SKUs over the entire fleet. We have uniqueness; we are not looking the same. As we said we’re taking out redundancies in our assortment. We were over assorted in Journey, we were over assorted in Circles, which everybody has. We believe the way to win is to make sure we have the right amount of SKUs but also have the right amount of newness that makes our assortments compelling.

Both our associates, our fine jewelry consultants will be excited to sell as well as our customers who will come in and see newness so we believe by just offering a great compelling assortment focused on our value customer that people are going to come in and see exciting things and whatever the fine jewelry customers are out there, we believe we want our unfair share of it and people will be so excited by our product and our marketing which is much more compelling which really celebrates product and the emotional part of the jewelry purchase as well as focusing on price only.

Bill Armstrong – CL King & Associates

You’re going to have a small net reduction in your store count this coming year, can you put some numbers to that and what brands would that be focused on mostly?

Rodney Carter

It will be mostly on kiosk with a slight reduction in jewelry stores overall and that number is yet to be determined based on final negotiations and final evaluations but I think also keep in mind that those are modest volume stores with modest store contributions so they shouldn’t effect your models that significantly.

Neal Goldberg

And our strongest desire is to keep on growing our franchise. We talked about our opportunities in Canada. We’ve spoken about our other opportunities and we are going to continue to look at opportunities to grow our franchise. With that said, with the proper financial rigor we will always be looking at stores that are doing well and stores that are not doing well and taking the ones that are not doing well out of the system which I think is the proper way to run a retail fleet.

Operator

Your next question comes from the line of Brian Tunick – JP Morgan

Brian Tunick – JP Morgan

Can you share with us your debt and cash plans for year end and inventory plans for year end and then margins by brand? I know you won’t give specific margins, but maybe rank them where we ended 2008 and where you see the biggest opportunity going forward in the margins by brands?

Rodney Carter

Inventory should be flat to slightly down this next year. That’s basically what we’re planning. Debt levels will be down noticeably given the free cash flow that we discussed. Overall we’re not going to discuss margins by brand. Obviously Pagoda historically has broken out of the higher margin business then the others but we’re very pleased with the margin structure and the opportunity overall and think that really the blended 52% or so that we talked about is the more relevant measure.

Neal Goldberg

We also believe based on our organizational structure having a separate sourcing team and merchandising team, Gil’s team is really doing a great job of going out. We’re getting orders in more, we’re being more planful. We are taking advantage of a smaller vendor base to really make sure we drive the best quality as well as best cost opportunities. Also we will be during the key promotional times, we will be aggressive promotionally, but throughout the year, throughout all of the time periods we are going to focus our marketing much more on the emotional, much more on product supported by price. We think with compelling assortments, with much better presentation there should be margin opportunities there.

Brian Tunick – JP Morgan

Is there a debt to cap level that you’re comfortable running with or a minimum cash balance that we should be thinking about?

Rodney Carter

Its overall balance of liquidity. We’ll talk more about it in coming quarters. Obviously we’re gearing up to make sure we have a balance of the strategic financial flexibility that we need to have and feel that we’re in good shape on that. Obviously the debt levels are higher at year end then we anticipated a lot of it due to the timing of $40 million change of between investments and the tax refund which we got back in two weeks into the new fiscal year.

Brian Tunick – JP Morgan

Any comments on regional performance?

Neal Goldberg

No, sorry. We see pretty much, what I’ve been reading about everybody else is pretty true to our performance. From a region which is a very big region, which happens to be a country, Canada is still performing very, very well for us. We’re very excited about that and we’re seeing pockets of strength in many parts of the country so as we have our focus on really the stores and especially our pacesetter program we’re very pleased with the results throughout the country.

Operator

Your next question comes from the line of Janet Kloppenburg - JJK Research

Janet Kloppenburg - JJK Research

On the pacesetter stores, is there an opportunity to expand that base of stores and is there a lot of untapped potential in those stores still at this point? I wonder what your inventory planning looked like going forward, I know what your comp guidance is and I’m wondering what we should expect in terms of inventory increases and them maybe talk more about direct sourcing?

Neal Goldberg

On the pacesetter, first of all we’ve said we really wanted a great focus group of stores we could use as laboratories to get great learnings. In the 135 pacesetter stores we’re seeing there huge amounts of opportunity to really drive the sales and profitability of those stores. We’re excited by the talent we have in those stores as we are across all of our fleet and we’re excited about the assortments we’re putting into those stores. We will continue to evaluate the size of the pacesetter program but understand the purpose of it is to take the learnings we have in the pacesetters and migrate those across the fleet. So we have some good learnings. We are going to move very quickly to get those across all of the stores.

Rodney Carter

I think the key on the inventory, the comment I just made was relative to year end and will be flat to slightly down. We’ll be noticeably higher year-over-year at the end of Q1 as we intentionally have brought in inventory in advance of holiday. Last year we brought a lot of things in early to mid part of the second quarter which we do believe were advantageous.

Janet Kloppenburg - JJK Research

I’m confused, at the end of the first quarter we should expect inventory to be where?

Rodney Carter

Inventory is going to be, we’re not going to see the big year-over-year save in Q1 because there was such a low level of inventory in Q1 last year and this year we’ve intentionally brought in inventory in advance. We’re still going to preserve the $100 million in permanent savings for the year and we’ll actually be flat to down for the year but there were some timing differences in Q1 between the two years.

Janet Kloppenburg - JJK Research

So we should expect inventory to be up at the end of the first quarter?

Rodney Carter

That’s correct.

Janet Kloppenburg - JJK Research

Order of magnitude?

Rodney Carter

Not significant, but you’ll see inventory in Q2 year-over-year down by well over $100 million.

Janet Kloppenburg - JJK Research

What’s happening with global direct sourcing?

Neal Goldberg

We are so excited about having a separate sourcing and merchandising organization applying the expertise of Gil and his team to make sure we are getting the most favorable pricing, as important the most favorable quality, great quality, and that we’re also making sure our deliveries are on time.

Gil Hollander

First of all I’d like to say that the sourcing organization is all sourcing, it’s not just direct sourcing. Direct sourcing as we define it is when we work directly with factories and we take out all value added out of the proposition so its essentially contracting. We also do direct sourcing in our own facility here in Dallas and in Canada. The direct source product is the product which we feel most comfortable with as there’s little or no risk to it, its very predictable product. So we will appropriately expand on direct sourcing based on the needs of the corporation, things like memo or return privileges, affectability to go direct or not. We have committed to better quality, better cost and better delivery throughout our assortment which includes direct sourcing as well as non-direct sourcing.

Neal Goldberg

And we have in the past spoken about we have goals for how much we source out, out of this building. Our most important goal is to get the best price and the best quality and we will either do it here or with our vendor partners. We are not fixated on doing x percent of our business or our sourcing out of this building and real direct sourcing.

Janet Kloppenburg - JJK Research

Can you talk a little about your promotional strategy for the holiday season? Do you think you’ll plan work on a more full price basis or do you think you’ll be very competitive given (a) the environment and (b) the liquidation events going on with some other retailers?

Neal Goldberg

We feel we have a very robust marketing calendar. We will make sure that on the key holidays and key promotional times that we know people will be involved and we will be extremely competitive. We’re very excited about those periods of time. That said, throughout the year we also are going to make sure our marketing reflects emotion that should be in a business that delivers love, that we are going to be celebrating product and supported by price so it’ll be what we feel is the proper balance and mix of our marketing calendar and we certainly live in an environment where everybody else does and we will be sure on those key promotional periods, those key holidays, we will be aggressive.

Janet Kloppenburg - JJK Research

I think you said SG&A rate 46% for fiscal 2009, is that right?

Rodney Carter

That is right.

Operator

Your next question comes from the line of Jeff Stein - Soleil Securities

Jeff Stein - Soleil Securities

You stated the comp store comparisons; I just wanted to make sure those were for the year and not for the quarter? You said Zale and Gordon’s minus 4.8% and so forth, is that for the year?

Rodney Carter

That’s correct.

Jeff Stein - Soleil Securities

Can you talk a little about what’s going on at Peoples, you did mention the economy is a little bit stronger up there, but are they ahead of the curve with regard to what you’re trying to accomplish domestically and if so, what best practices are you pulling away from those locations?

Neal Goldberg

First and foremost clearly the Canadian economy is a strong economy, I guess when you have a lot of oil in the ground and I believe a budget surplus for the country, it helps the economy. Second we have a tremendous team in Canada that has been a very stable team of associates, of management there. Third we believe the learnings are and that we’ve seen and what’s so exciting to us is the potential by really as I call feeding the beast that we can really make sure we even improve our assortments by giving better quality product to the Canadian stores. We think the potential there is great. We’re the number one fine jewelry retailer in Canada and we just think the potential there is pretty spectacular.

Jeff Stein - Soleil Securities

I didn’t hear CapEx or D&A projections for the current year?

Rodney Carter

CapEx is going to be about $45 million as we’ve shared previously.

David Sternblitz

D&A is pretty consistent, about $64 million.

Jeff Stein - Soleil Securities

And the gross margin of 52 is that what you would expect for the full year or is that where you should be by the back half of the year?

Rodney Carter

Full year.

Jeff Stein - Soleil Securities

Do you see off mall opportunities for Zale? One of your competitors is very successfully expanding off mall and wondering if you see that as a growth opportunity domestically?

Neal Goldberg

We’re so excited about the opportunities we have and certainly with the Zale brand being the number one brand to consumers we see there is definite potential to go off mall. We feel we have great potential in Canada. We’ve talked about our pacesetter programs. We think we can get a lot more efficiency out of our existing fleet and certainly we’ve talked about our Outlet business before which we see opportunistically as well as the opportunity to go after the off mall business. Again when you’re blessed with the number one brand name in the fine jewelry business it gives us a lot of opportunity.

Operator

Your final question comes from the line of David Mann - Johnson Rice

David Mann - Johnson Rice

The Celebration diamond rollout, can you talk about some of the initial customer response to that?

Neal Goldberg

The customer response has been very, very exciting. We have just really done a soft rollout, the re-launch of it will be later in the fall season but the initial response of just the product without the corresponding elements in case, without the corresponding marketing we are cautiously optimistic and leaning to the excited stage with it as well as, as importantly our associates are very excited about it.

David Mann - Johnson Rice

One of the things I’ve noticed in some of the stores where I’ve seen the Celebration it seems like they’re at somewhat higher price points, in general can you talk about that or areas where you are taking up price points and how in general the customer is responding to that and perhaps what kind of price increases or higher price points in magnitude are you taking?

Neal Goldberg

As I said in my prepared remarks we will always look surgically at our pricing to make sure that we have the right pricing bands focused on our value oriented customers. Celebration we are just so proud of that, of the quality of the stone, of the light level of the stone, that we really priced it what we thought would be very fair in the marketplace knowing that we believe it is the best-in-class. We will always evaluate very carefully each item, each SKU we have, micro manage that to make sure we are getting the right amount of gross margin dollars out of that.

Sometimes we will look at a lower gross margin dollar because we’re going after volume. Sometimes we will look at something because of the uniqueness of it that we can get more price out of it. So we really look at it surgically and making sure we stay very aware of what are the pricing advantage of our value oriented customer will accept and we think we can get rewarded because of the newness, because of the differentiation in our inventories that we will have from other people.

David Mann - Johnson Rice

On the training and personnel side this company has talked often times in the past about efforts to improve their employee base and customer interaction, can you talk a bit about what you’re doing, why you think you’re going to get some traction and also highlight some of the compensation changes that you talked about in the script?

Neal Goldberg

One of the things, we have an amazingly strong fine jewelry consultant team in the field. We have given them a lot of training over many, many years. One of the things we did not do a good job is listen to them and respect them and we have done a much better job being in the field, listening to the consultants, taking care of their needs so they can provide much better service levels to the customer. That in itself is a huge change.

Theo Killion

First on the point that Neal made, we started going to stores in January and listening to the stores and as Neal also said, we brought in our regional directors, our district managers, and our top jewelry consultants for three days and what they saw was that all of the things that made sense that they were asking for were put into place. So no longer do they sit out and represent the voice of our customer and not have it heard in the Store Support Center, they now actually see that the people who are supporting them here are doing what they say.

We think that will give us more traction then a program which may be episodic. However we are continuing to train people in diamond certification. We think that is important to get authority and to give our associates confidence. We think its important to continue to train in skills like recruiting and running a selling floor which we have been doing but the most important thing that we’re doing is to listen to the field, we’ll have an aggressive schedule in the holiday season for all of our senior leaders who will be out in the field and talking to our associates and we think they’re pretty excited about what they’ve seen here.

In terms of the compensations systems what we’ve really done, it was trailing event. We’ve made lots of changes here in Dallas in collapsing all of the functional silos. What we hadn’t done was to put together all of our compensation systems so that we could leverage the talent that we have brand by brand. We now have consistent compensation systems in our brands so that we can move a person from one brand to another and be able to leverage the strength that we have with all of our sister businesses.

Neal Goldberg

In closing I’d like to thank our dedicated and passionate team from our 1,400 associates with 10 plus years to our newest employees for their hard work in fiscal 2008 and in advance for being our difference makers in 2009. We recognize there is much more to do to reach our goals and we will continue to operate with the same sense of urgency. Thank you everybody.

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Source: Zale Corporation F4Q08 (Qtr End 07/31/08) Earnings Call Transcript
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