Earnings Preview: Zale Corporation

| About: Zale Corporation (ZLC)
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I have prepared my notes for Zale Corporation's (NYSE:ZLC) 2nd quarter 2007 earnings call tomorrow, Wednesday, 21 February 2007, before the market opens. Zale's fiscal year end is July 31st.

For those unfamiliar with Zale, it is one of North America's largest jewelry retailers with about 2,400 locations in U.S., Canada, and Puerto Rico. It has four main brands in the U.S.: Bailey Banks & Biddle Fine Jewelers, Gordon's Jewelers, Zales Jewelers, and Piercing Pagoda. In Canada, it sports two major brands: Peoples Jewelers and Mappins Jewellers. The company also has an online store and sells jewelry insurance.

Key Zale's earnings and revenue estimates from Yahoo are as follows:


  • Average Earnings Estimate (Current Quarter–Jan 07): $1.89 (see Recent Press Release);
  • Average Earnings Estimate (Next Quarter–Apr 07): $0.25;
  • Average Earnings Estimate (Current Year–Jul 07): $1.68; and
  • Average Earnings Estimate (Next Year–Jul 08): $2.01.
  • Revenue

  • Average Earnings Estimate (Current Quarter–Jan 07): $1.02B (see Recent Press Release);
  • Average Earnings Estimate (Next Quarter–Apr 07): $550.67M;
  • Average Earnings Estimate (Current Year–Jul 07): $2.52B; and
  • Average Earnings Estimate (Next Year–Jul 08): $2.63B.
  • Comments On Past Conference Call

    I will discuss some quick highlights from the company's last earnings conference call transcript. (I use Seeking Alpha as my source for conference call transcripts.)

    The company began the conference call with a mixed bag of good and bad news.

    On to Q1 results. Q1 operating results were on plan. Excluding the impact of derivative accounting, we delivered a net loss of $0.45 per share on overall revenue growth of approximately 3% excluding the Bailey Banks & Biddle store closures. Comp store sales increased 0.4%, impacted in large part by the mix of clearance sales at the Zales brand. While the number of customer transactions increased, this was offset by a lower average ticket.

    This was consistent with our plan to move through as much non-program merchandise as possible in Q1, to make way for fresh assortments and selling of regular priced goods in the all-important holiday season. This resulted in the mix of clearance sales this year representing 20% of total sales, versus 5% last year. The good news is we moved through almost $20 million of clearance goods at the Zales brand, and are ahead of plan.

    In terms of the other brands, both Canada and Outlet had an outstanding quarter, fueled by high single digit comp growth. Margins were also strong, with an 80 basis point improvement over last year. Canada experienced an almost 200 basis point improvement, due in large part to a new direct sourcing initiative for finished goods diamond fashion.

    Good news: Q1 results were largely on plan and Canada and Outlet were doing well. Bad news: derivative losses, low comp sales increase, clearance sales, and lower average ticket prices. Unless a company needs to reduce its exposure—I mean needs to—I do not like seeing derivatives. These executives have little experience in trading and are likely to hedge just when they begin feeling some pain and just when prices are about to peak. Hedging is a zero sum game, and I do not see why these executives would outsmart the market and be on the winning side of the trade. Lower comp sales and clearance sales indicate problems with not moving merchandise and inventories.

    The company announced $120 million in new inventory with $47 million in bridal and $45 million in diamond fashion.

    The company mentioned that during the prior quarter, it had 5 million unique visitors to its online store and shipped over 20,000 orders. Later during the question and answer session, the company indicated that the average online purchase was about $240.

    Gross margin last quarter was 52%. SG&A was 55.2% as a percentage of revenue. Think about those two statements for a moment. Effectively, the sum of cost of goods sold and SG&A equal revenue.

    In order to plan our inventory purchases of gold and silver, for which commodity prices have fluctuated greatly, we entered into forward hedge contracts. We believe hedge contracts to be economically effective in establishing our purchase cost of inventory, and insulating us from significant cash flow fluctuations due to changing commodity prices.


    The offsetting increase or decrease in product costs will flow through the income statement over time as the inventory is sold. For the first quarter, we recognized $5.4 million after-tax or $0.11 per share from the derivative loss.

    When times are normal and commodity prices are stable, the company will have no desire to hedge. As I wrote earlier, when commodity prices are volatile and the company's executive are feeling some pain, the company will hedge, often much too late. I am curious to see if we see more hedging losses again this past quarter.

    The company goes on to discuss its reasons for having a loss during its fiscal Q1 2007. Reasons include derivatives, hedge accounting, and impairment of the Bailey Banks & Biddle closed store assets.

    Zales has earmarked $87 million in capital expenditures for the fiscal year with a target of 60 new stores. Recall earlier that the company invested $127 million in inventory as well.

    In the question and answer session, the company that it started with about $80 million of clearance, non-going forward merchandise. In Q1, it moved about $20 million with about $15 million remaining. The company returned what it could and is doing its best to move the rest.

    When asked about share repurchases, the company responded that company would assess its position after the holiday season.

    Recent Press Release

    The company recently issued a press release (SEC site) where it provided the following key metrics:

  • Comparable Store Sales: Increased 1.4%;
  • Total Revenue for Q2: $1.09B (higher than estimates—see Estimates From Yahoo);
  • Last Year's Revenue: $979M;
  • Increased Revenue by 4.1%;
  • Year-to-Date Total Revenues (excluding store closures): $1.452B, an increase of 3.9%;
  • Year-to-Date Total Revenues (including store closures): $1.421B, an increase of 2.2%; and
  • Year-to-Date Comparable Store Sales (excluding store closures): 1.1%.
  • The company indicated that it was comfortable with the higher end of its previous guidance for Q2 of $1.85 to $1.90.

    Summary Comments

    My impression is that Zale is trying to fixing some broken strategies. The company has not been performing well and it is having difficulty moving merchandise. The company is spending on revamping its assortment of jewelry.

    I am going to be listening to learn how the company performed over the holiday and Valentine seasons. I also want to learn how the company is doing with respect to its inventory. I also want to see if the company can reduce its cost structure. With online jewelry sales with lower gross margins becoming more commonplace, Zale might soon find that its gross margin of 52% is unsustainable over the longer term. I am also going to be listening to the body language—the general tone of the conversation. And, of course, I will be listening to the forward outlook and guidance.

    Disclosure: I am short Zale Corporation.