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ZLC > SEC Filings for ZLC > Form 10-K on 27-Sep-2013All Recent SEC Filings

Show all filings for ZALE CORP

Form 10-K for ZALE CORP


27-Sep-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

For important information regarding forward-looking statements made in this Management's Discussion and Analysis of Financial Condition and Results of Operations see "Item 1A-Risk Factors."

Overview of Fiscal Year 2013

We are a leading specialty retailer of fine jewelry in North America. At July 31, 2013, we operated 1,064 fine jewelry stores and 630 kiosks located primarily in shopping malls throughout the United States, Canada and Puerto Rico.

We report our business under three operating segments: Fine Jewelry, Kiosk Jewelry and All Other. Fine Jewelry is comprised of our three core national brands, Zales Jewelers®, Zales Outlet® and Peoples Jewellers® and our two regional brands, Gordon's Jewelers® and Mappins Jewellers®. Each brand specializes in fine jewelry and watches, with merchandise and marketing emphasis focused on diamond products. These five brands have been aggregated into one reportable segment. Kiosk Jewelry operates under the brand names Piercing Pagoda®, Plumb Gold™, and Silver and Gold Connection® through mall-based kiosks and is focused on the opening price point guest. Kiosk Jewelry specializes in gold, silver and non-precious metal products that capitalize on the latest fashion trends. All Other includes our insurance and reinsurance operations, which offer insurance coverage primarily to our private label credit card guests.

Comparable store sales increased by 3.3 percent during fiscal year 2013. At constant exchange rates, which excludes the effect of translating Canadian currency denominated sales into U.S. dollars, comparable store sales increased by 3.1 percent during fiscal year 2013. Gross margin increased by 60 basis points to 52.1 percent for the fiscal year ended July 31, 2013 compared to the prior year. The increase is primarily due to the relatively stable commodity cost environment compared to the prior year resulting in a lower last-in, first-out ("LIFO") inventory charge. Net earnings for fiscal year 2013 were $10.0 million compared to a net loss of $27.3 million in the prior year. The $37.3 million improvement is primarily the result of an increase in gross margin and a $21.5 million decrease in interest expense, partially offset by a $14.0 million increase in selling, general and administrative expense ("SG&A").

Revenues associated with warranties totaled $147.4 million during fiscal year 2013 compared to $146.8 million in the prior year. The increase in fiscal year 2013 is primarily due to higher warranty cash sales compared to the prior year. Gross margin associated with warranties totaled $120.1 million during fiscal year 2013 compared to $120.8 million in the prior year.

In fiscal year 2013, we achieved several important milestones and continued to take steps that we believe will generate significant financial improvement and increase shareholder value, including:

º •
º improved net earnings by $37.3 million to $10.0 million, achieving our goal of generating positive net earnings for the first time since fiscal year 2008;

º •
º increased the mix of our exclusive, branded merchandise to 11 percent of Fine Jewelry's revenues in fiscal year 2013, compared to 8 percent in the prior year;


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º •
º launched a multi-year sourcing initiative as a catalyst to achieving future gross margin improvement;

º •
º signed a multi-year Private Label Credit Card Program agreement with Alliance Data Systems Corporation ("ADS") to provide private label credit card financing for our U.S. guests at significantly lower merchant fees, while also providing key marketing, analytical and technical services designed to generate sales and enhance brand affinity;

º •
º reduced our outstanding debt balance by $43 million;

º •
º continued to expand our omnichannel business model to provide guests access to our brands wherever and whenever they choose through webstores, mobile devices, social media and traditional stores; and

º •
º strengthened the stewardship of the Company by appointing Terry Burman Chairman of our Board of Directors.

Outlook for Fiscal Year 2014

In fiscal year 2014, we will continue to invest in the business to drive profitable growth and increase shareholder value. We expect to achieve this growth as a result of:

º •
º an increase in revenues driven by positive comparable store sales in our Zales and Peoples brands and the growth of our exclusive, branded merchandise;

º •
º gross margin improvement related primarily to benefits from the sourcing initiative launched in fiscal year 2013 and a more favorable commodity cost environment;

º •
º slightly higher selling, general and administrative expenses, as a percent of revenues, due to initiatives targeted at driving future revenue growth;

º •
º an improvement in operating margin of 50 basis points or more;

º •
º interest expense consistent with fiscal year 2013; and

º •
º income tax expense of $2 million to $3 million.

We anticipate capital expenditures will be between $40 million and $45 million in fiscal year 2014. The increase in capital expenditures compared to the $23 million spent in fiscal year 2013 is primarily the result of new store openings, refurbishment of existing stores, upgrades to our point-of-sale hardware and software and improved connectivity in our stores. We expect net store closures in fiscal year 2014 of 50 to 55 locations, primarily in Gordon's and Mappins. The closures are expected to impact total revenues by approximately 250 basis points.

Comparable Store Sales

Comparable store sales include internet sales and repair sales but exclude revenue recognized from warranties and insurance premiums related to credit insurance policies sold to guests who purchase merchandise under our proprietary credit programs. The sales results of new stores are included beginning with their thirteenth full month of operation. The results of stores that have been relocated, renovated or refurbished are included in the calculation of comparable store sales on the same basis as other stores. However, stores closed for more than 90 days due to unforeseen events (e.g., hurricanes, etc.) are excluded from the calculation of comparable store sales.


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The following table presents comparable store sales for each of our brands for the periods indicated.

                                                          Year Ended July 31,
       Comparable Store Sales                           2013      2012      2011
       Zales                                              4.9 %    11.0 %     8.4 %
       Outlet                                             3.3 %     9.6 %     8.8 %
       Peoples                                            5.7 %     4.3 %    14.0 %
       Gordon's                                          (3.6 )%    1.7 %     3.6 %
       Mappins                                           (6.7 )%   (1.5 )%   11.9 %
       Piercing Pagoda                                    1.3 %    (1.0 )%    3.6 %
       Total Company                                      3.3 %     6.9 %     8.1 %
       Comparable Store Sales (in constant currency)
       Peoples                                            4.8 %     5.9 %     7.9 %
       Mappins                                           (7.5 )%    0.1 %     5.9 %

Non-GAAP Financial Measure

We report our consolidated financial statements in accordance with U.S. generally accepted accounting principles ("GAAP"). However, the non-GAAP performance measure of EBITDA (defined as earnings before interest, income taxes and depreciation and amortization) is presented to enhance investors' ability to analyze trends in our business and evaluate our performance relative to other companies. We use the non-GAAP financial measure to monitor the performance of our business and assist us in explaining underlying trends in the business.

EBITDA is a non-GAAP financial measure and should not be considered in isolation of, or as a substitute for, net earnings (loss) or other GAAP measures as an indicator of operating performance. In addition, EBITDA should not be considered as an alternative to operating earnings (loss) or net earnings (loss) as a measure of operating performance. Our calculation of EBITDA may differ from others in our industry and is not necessarily comparable with similar titles used by other companies.

The following table reconciles EBITDA to earnings (loss) from continuing operations as presented in our consolidated statements of operations:

                                                         Year Ended July 31,
                                                    2013       2012         2011
     Earnings (loss) from continuing operations   $ 10,012   $ (26,896 ) $ (112,042 )
     Depreciation and amortization                  33,770      37,887       41,326
     Interest expense                               23,182      44,649       82,619
     Income tax expense                              1,924       1,365        1,557

     EBITDA                                       $ 68,888   $  57,005   $   13,460


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Results of Operations

The following table sets forth certain financial information from our audited consolidated statements of operations expressed as a percentage of total revenues and should be read in conjunction with our consolidated financial statements and notes thereto included elsewhere in this Form 10-K.

                                                          Year Ended July 31,
                                                       2013      2012       2011
    Revenues                                            100.0 %   100.0 %    100.0 %
    Cost of sales                                        47.9      48.5       49.5

    Gross margin                                         52.1      51.5       50.5
    Selling, general and administrative                  48.5      48.3       49.3
    Depreciation and amortization                         1.8       2.0        2.4
    Other (gains) charges                                   -       0.1        0.4

    Operating earnings (loss)                             1.9       1.0       (1.6 )
    Interest expense                                      1.2       2.4        4.7

    Earnings (loss) before income taxes                   0.6      (1.4 )     (6.3 )
    Income tax expense                                    0.1       0.1        0.1

    Earnings (loss) from continuing operations            0.5      (1.5 )     (6.4 )
    Loss from discontinued operations, net of taxes         -         -          -

    Net earnings (loss)                                   0.5 %    (1.5 )%    (6.4 )%

Year Ended July 31, 2013 Compared to Year Ended July 31, 2012

Revenues. Revenues for fiscal year 2013 were $1,888.0 million, an increase of 1.1 percent compared to revenues of $1,866.9 million in the prior year. Comparable store sales increased 3.3 percent as compared to the prior year. The increase in comparable store sales was attributable to a 3.2 percent increase in the average price per unit and a 2.4 percent increase in the number of units sold in our bridal product lines, partially offset by a decrease in the number of units sold in Fine Jewelry's core fashion product lines. The increase was partially offset by a decrease in revenues related to 84 store closures since July 31, 2012 (net of store openings).

Fine Jewelry contributed $1,637.4 million of revenues in the fiscal year ended July 31, 2013, an increase of 1.2 percent as compared to $1,617.7 million in the prior year.

Kiosk Jewelry contributed $239.7 million of revenues in the fiscal year ended July 31, 2013, an increase of 0.4 percent compared to $238.7 million in the prior year. The increase in revenues is due to a 4.5 percent increase in the average price per unit, partially offset by a 2.9 percent decrease in the number of units sold. The increase was partially offset by a decrease in revenues related to 24 kiosk closures since July 31, 2012 (net of openings).

All Other contributed $10.9 million in revenues for the fiscal year ended July 31, 2013, an increase of 4.1 percent compared to $10.5 million in the prior year.

During the fiscal year ended July 31, 2013, we closed 61 stores in Fine Jewelry and 36 locations in Kiosk Jewelry. In addition, we opened one store in Fine Jewelry and 12 locations in Kiosk Jewelry.

Gross Margin. Gross margin represents net sales less cost of sales. Cost of sales includes cost related to merchandise sold, receiving and distribution, guest repairs and repairs associated with warranties. Gross margin was 52.1 percent of revenues for the year ended July 31, 2013, compared to 51.5 percent in the prior year. The 60 basis point improvement is due primarily to the relatively stable commodity cost environment compared to the prior year resulting in a lower LIFO inventory charge.


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Selling, General and Administrative. Included in SG&A are store operating, advertising, buying, cost of insurance operations and general corporate overhead expenses. SG&A was 48.5 percent of revenues for the year ended July 31, 2013, compared to 48.3 percent in the prior year. SG&A increased by $14.0 million to $916.3 million for the year ended July 31, 2013. The increase is related to a $24.9 million increase in costs associated primarily with performance-based compensation related to improved earnings, initiatives involving merchandise sourcing and training, consulting fees and our special events program that began in the second quarter of the prior year. The increase was partially offset by a $10.9 million decrease in promotional costs, including $2.9 million related to production costs.

Depreciation and Amortization. Depreciation and amortization as a percent of revenues for the year ended July 31, 2013 and 2012 was 1.8 percent and 2.0 percent, respectively. The decrease is primarily related to 84 stores closed (net of store openings) during fiscal year 2013 and an increase in the number of fully depreciated assets compared to the prior year, partially offset by additional capital expenditures.

Other (Gains) Charges. Other gains for the year ended July 31, 2013 includes proceeds totaling $2.2 million related to the De Beers settlement, partially offset by a $1.1 million charge related to the impairment of long-lived assets associated with underperforming stores and a $0.3 million charge associated with store closures. Other charges for the year ended July 31, 2012 includes a $1.8 million charge related to the impairment of long-lived assets associated with underperforming stores and a $0.2 million charge associated with store closures.

Interest Expense. Interest expense as a percent of revenues for the years ended July 31, 2013 and 2012 was 1.2 percent and 2.4 percent, respectively. Interest expense decreased by $21.5 million to $23.2 million for the year ended July 31, 2013. The decrease is due primarily to the debt refinancing transactions completed in July 2012, which resulted in an effective interest rate of 3.8 percent for fiscal year 2013, compared to 7.4 percent in the prior year. In addition, interest expense in the prior year included a $5.0 million charge as a result of an amendment to the term loan in July 2012. The decrease was partially offset by an increase in the average borrowings in fiscal year 2013 compared to the prior year.

Income Tax Expense. Income tax expense totaled $1.9 million for the year ended July 31, 2013, compared to $1.4 million in the prior year. Income tax expense for the year ended July 31, 2013 is primarily associated with operating earnings related to our Canadian subsidiaries. Income tax expense for the year ended July 31, 2012 is primarily associated with operating earnings related to our Canadian subsidiaries, partially offset by the release of certain state tax reserves totaling $1.7 million.

Year Ended July 31, 2012 Compared to Year Ended July 31, 2011

Revenues. Revenues for fiscal year 2012 were $1,866.9 million, an increase of 7.1 percent compared to revenues of $1,742.6 million in the prior year. Comparable store sales increased 6.9 percent as compared to the prior year. The increase in comparable store sales was attributable to an 8.4 percent increase in the number of units sold in our fine jewelry stores, partially offset by a 0.5 percent decrease in the average price per unit. The increase in revenues was also due to a $49.9 million increase in revenues related to warranties, of which $34.9 million is the result of a change in revenue recognition related to lifetime warranties. The increase was partially offset by a decrease in revenues related to 51 store closures (net of store openings) during fiscal year 2012.

Fine Jewelry contributed $1,617.7 million of revenues in the fiscal year ended July 31, 2012, an increase of 8.3 percent as compared to $1,493.3 million in the prior year.

Kiosk Jewelry contributed $238.7 million of revenues in the fiscal year ended July 31, 2012, a decrease of 0.2 percent compared to $239.2 million in the prior year. The decrease in revenues is due to a 6.1 percent decrease in the number of units sold, partially offset by a 5.5 percent increase in average price per unit.


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All Other contributed $10.5 million in revenues for the fiscal year ended July 31, 2012, an increase of 4.6 percent compared to $10.0 million in the prior year.

During the fiscal year ended July 31, 2012, we converted nine Gordon's stores to the Zales nameplate and one Zales store to the Zales Outlet nameplate in Fine Jewelry. We opened two locations in Kiosk Jewelry. In addition, we closed 49 stores in Fine Jewelry and 14 locations in Kiosk Jewelry.

Gross Margin. Gross margin represents net sales less cost of sales. Cost of sales includes cost related to merchandise sold, receiving and distribution, guest repairs and repairs associated with warranties. Gross margin increased by 100 basis points to 51.5 percent during fiscal year 2012. Gross margin compared to the prior year was impacted by a 90 basis point improvement resulting from a change in warranty revenue recognition and a 30 basis point LIFO inventory charge. Excluding these items, gross margin improved by 40 basis points as a result of an increase in retail prices and lower merchandise discounts, partially offset by an increase in the cost of merchandise.

Selling, General and Administrative. Included in SG&A are store operating, advertising, buying, cost of insurance operations and general corporate overhead expenses. SG&A was 48.3 percent of revenues for the year ended July 31, 2012, compared to 49.3 percent in the prior year. SG&A increased by $42.7 million to $902.3 million for the year ended July 31, 2012. The increase is primarily the result of an $18.0 million increase in promotional costs, including production costs and marketing for the launch of proprietary products during the second quarter, an $11.1 million increase in labor costs to support increased sales, an $11.4 million increase in proprietary credit fees and a $3.1 million increase in professional fees. The increase was partially offset by a $3.6 million decrease in occupancy costs primarily related to 51 stores closed (net of store openings) during fiscal year 2012.

Depreciation and Amortization. Depreciation and amortization as a percent of revenues for the year ended July 31, 2012 and 2011 was 2.0 percent and 2.4 percent, respectively. The decrease is primarily related to 51 stores closed (net of store openings) during fiscal year 2012.

Other Charges. Other charges for the year ended July 31, 2012 includes a $1.8 million charge related to the impairment of long-lived assets associated with underperforming stores and a $0.2 million charge associated with store closures. Other charges for the year ended July 31, 2011 includes a $6.8 million charge related to the impairment of long-lived assets associated with underperforming stores and a $0.3 million charge associated with store closures.

Interest Expense. Interest expense as a percent of revenues for the years ended July 31, 2012 and 2011 was 2.4 percent and 4.7 percent, respectively. Interest expense decreased by $38.0 million to $44.6 million for the year ended July 31, 2012. The decrease is the result of a $45.8 million charge recorded in the first quarter of fiscal year 2011 related to an amendment to the term loan on September 24, 2010, partially offset by a $5.0 million charge recorded in the fourth quarter of fiscal year 2012 as a result of an amendment to the term loan on July 24, 2012. Excluding these charges, interest expense increased $2.9 million due primarily to an increase in the average borrowings compared to the prior year.

Income Tax Expense. Income tax expense totaled $1.4 million for the year ended July 31, 2012, compared to $1.6 million in the prior year. Income tax expense for the year ended July 31, 2012 is primarily associated with operating earnings related to our Canadian subsidiaries, partially offset by the release of certain state tax reserves totaling $1.7 million. Income tax expense for the year ended July 31, 2011 is primarily associated with operating earnings related to our Canadian subsidiaries, partially offset by the recognition of a $4.6 million tax refund associated with the Worker, Homeownership and Business Assistance Act of 2009.


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Liquidity and Capital Resources

Our cash requirements consist primarily of funding ongoing operations, including inventory requirements, capital expenditures for new stores, renovation of existing stores, upgrades to our information technology systems and distribution facilities, and debt service. Our cash requirements are funded through cash flows from operations and our revolving credit agreement with a syndicate of lenders led by Bank of America, N.A. We manage availability under the revolving credit agreement by monitoring the timing of merchandise purchases and vendor payments. At July 31, 2013, we had borrowing availability under the revolving credit agreement of approximately $242 million. The average vendor payment terms during the year ended July 31, 2013 and 2012 was approximately 56 days and 52 days, respectively. As of July 31, 2013, we had cash and cash equivalents totaling $17.1 million. We believe that our operating cash flows and available credit facility are sufficient to finance our cash requirements for at least the next twelve months.

Net cash provided by operating activities was $50.4 million for the year ended July 31, 2013, an improvement of $87.3 million compared to the net cash used in operating activities of $36.9 million in the prior year. The improvement is primarily the result of the $38.0 million commencement payment received related to the signing of the ADS Agreement in July 2013, a $20.8 million reduction in cash paid for interest and financing fees as a result of the debt refinancing transactions completed in July 2012, an increase in operating earnings and the timing of vendor payments. The improvement was partially offset by an increase in inventory.

The Company had total outstanding debt of $410.1 million as of July 31, 2013, a decrease of $42.9 million compared to $452.9 million as of July 31, 2012. The decrease is primarily related to the $38.0 million commencement payment received associated with the signing of the Private Label Credit Card Program agreement with ADS in July 2013.

Our business is highly seasonal, with a disproportionate amount of sales (approximately 30 percent) occurring in the Holiday season, which encompasses November and December of each year. Other important selling periods include Valentine's Day and Mother's Day. We purchase inventory in anticipation of these periods and, as a result, have higher inventory and inventory financing needs immediately prior to these periods. Inventory owned at July 31, 2013 was $767.5 million, an increase of $25.8 million compared to July 31, 2012. The increase is primarily due to the expansion of our bridal and exclusive, branded merchandise collections into additional stores and higher merchandise cost, partially offset by the impact of 84 store closures since July 31, 2012 (net of store openings).

Amended and Restated Revolving Credit Agreement

On July 24, 2012, we amended and restated our revolving credit agreement (the "Amended Credit Agreement") with Bank of America, N.A. and certain other lenders. The Amended Credit Agreement totals $665 million, including a $15 million first-in, last-out facility (the "FILO Facility"), and matures in July 2017. Borrowings under the Amended Credit Agreement (excluding the FILO Facility) are limited to a borrowing base equal to 90 percent of the appraised liquidation value of eligible inventory (less certain reserves that may be established under the agreement), plus 90 percent of eligible credit card receivables. Borrowings under the FILO Facility are limited to a borrowing base equal to the lesser of: (i) 2.5 percent of the appraised liquidation value of eligible inventory or (ii) $15 million. The Amended Credit Agreement is secured by a first priority security interest and lien on merchandise inventory, credit card receivables and certain other assets and a second priority security interest and lien on all other assets.

Based on the most recent inventory appraisal, the monthly borrowing rates calculated from the cost of eligible inventory range from 69 to 72 percent for the period of August through September 2013, 81 to 83 percent for the period of October through December 2013 and 68 to 73 percent for the period of January through July 2014.


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Borrowings under the Amended Credit Agreement (excluding the FILO Facility) bear interest at either: (i) LIBOR plus the applicable margin (ranging from 175 to 225 basis points) or (ii) the base rate (as defined in the Amended Credit Agreement) plus the applicable margin (ranging from 75 to 125 basis points). Borrowings under the FILO Facility bear interest at either: (i) LIBOR plus the applicable margin (ranging from 350 to 400 basis points) or (ii) the base rate plus the applicable margin (ranging from 250 to 300 basis points). We are also required to pay a quarterly unused commitment fee of 37.5 basis points based on the preceding quarter's unused commitment.

In September 2013, we executed interest rate swaps with Bank of America, N.A. to hedge the variability of cash flows resulting from fluctuations in the one-month LIBOR associated with our Amended Credit Agreement. The interest rate swaps will replace the one-month LIBOR with the fixed interest rates shown in the table below and will be settled monthly. The swaps qualify as cash flow hedges and, to the extent effective, changes in their fair values will be recorded in accumulated other comprehensive income in the consolidated balance sheet.

Interest rate swaps executed in September 2013 are as follows:

                                                Notional         Fixed
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