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ZLC > SEC Filings for ZLC > Form 10-Q on 7-Mar-2014All Recent SEC Filings

Show all filings for ZALE CORP

Form 10-Q for ZALE CORP


7-Mar-2014

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements of the Company (and the related notes thereto included elsewhere in this quarterly report), and the audited consolidated financial statements of the Company (and the related notes thereto) and Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's Annual Report on Form 10-K for the fiscal year ended July 31, 2013.

Overview

We are a leading specialty retailer of fine jewelry in North America. At January 31, 2014, we operated 1,037 fine jewelry stores and 623 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.

Revenues for the quarter ended January 31, 2014 decreased 2.1 percent compared to the same period in the prior year. The decrease in revenues was primarily the result of 86 store closures since January 31, 2013 (net of store openings) and the depreciation in the Canadian currency rate, partially offset by an increase in comparable store sales. Comparable store sales increased 0.6 percent during the second quarter of fiscal year 2014, or 1.9 percent at constant exchange rates. Gross margin increased by 240 basis points to 53.0 percent during the second quarter of fiscal year 2014 compared to the same quarter in the prior year. The increase is due primarily to benefits realized from our sourcing initiative launched in fiscal year 2013, lower commodity costs and a more disciplined approach to our promotional programs. Net earnings for the quarter were $50.8 million compared to $41.2 million for the same period in the prior year. The $9.6 million improvement is primarily the result of the increase in gross margin.

Revenues associated with warranties totaled $40.5 million and $41.3 million, respectively, during the three months ended January 31, 2014 and 2013 and $74.4 million and $75.6 million, respectively, during the six months ended January 31, 2014 and 2013. Gross margin associated with warranties totaled $32.7 million and $34.2 million, respectively, during the three months ended January 31, 2014 and 2013 and $60.1 million and $62.3 million, respectively, during the six months ended January 31, 2014 and 2013.

On February 19, 2014, the Company entered into the Merger Agreement with Signet and Merger Sub, providing for, subject to the satisfaction or waiver of specified conditions, the acquisition of the Company by Signet at a price of $21 per share in cash. Subject to the terms and conditions of the Merger Agreement, Merger Sub will be merged with and into the Company, with the Company surviving as a wholly owned subsidiary of Signet. For additional information regarding the Merger and the Merger Agreement, please refer to the February 19th 8-K. The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the Merger Agreement, a copy of which is attached as Exhibit 2.1 to the February 19th 8-K.

In connection with the Merger, the Company intends to file relevant materials with the SEC, including the Company's proxy statement in preliminary and definitive form. Stockholders of the Company are urged


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to read all relevant documents filed with the SEC, including the Company's proxy statement when it becomes available, because they will contain important information about the Merger. Investors and security holders will be able to obtain the documents (once available) free of charge at the SEC's web site, http://www.sec.gov, or for free from the Company by contacting its Investor Relations department by phone at (972) 580-4391 or by e-mail at ir@zalecorp.com.

Outlook for Fiscal Year 2014

The fiscal year 2014 outlook excludes the impact of the Merger and other transactions contemplated by the Merger Agreement.

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 positive comparable store sales in our Zales and Peoples brands and the growth of our exclusive, branded merchandise, offset by net store closures and the impact of the Canadian exchange rate;

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 primarily 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 $45 million and $50 million in fiscal year 2014. The increase in capital expenditures compared to the $21 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 70 to 75 locations, primarily in Gordon's, Mappins and Piercing Pagoda. The closures are expected to impact total revenues by approximately 280 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 presented:

                                                    Three Months          Six Months
                                                        Ended               Ended
                                                     January 31,         January 31,
                                                   2014       2013      2014      2013
  Comparable Store Sales
  Zales                                               4.0 %     3.7 %     5.4 %     4.1 %
  Zales Outlet                                        3.2 %     3.6 %     3.5 %     3.7 %
  Peoples                                            (4.3 )%    6.4 %    (1.8 )%    7.2 %
  Gordon's                                           (4.5 )%   (3.3 )%   (4.3 )%   (3.0 )%
  Mappins                                           (11.4 )%   (5.6 )%   (8.2 )%   (5.6 )%
  Piercing Pagoda                                    (4.6 )%    1.0 %    (3.5 )%    1.4 %
  Total Company                                       0.6 %     2.8 %     1.9 %     3.2 %
  Comparable Store Sales (in constant currency)
  Peoples                                             2.7 %     3.0 %     4.6 %     4.4 %
  Mappins                                            (4.9 )%   (8.6 )%   (2.2 )%   (8.1 )%
  Total Company                                       1.9 %     2.2 %     3.0 %     2.7 %

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 or other GAAP measures as an indicator of operating performance. In addition, EBITDA should not be considered as an alternative to operating earnings or net earnings 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 net earnings as presented in our consolidated statements of operations:

                                         Three Months Ended       Six Months Ended
                                            January 31,             January 31,
                                          2014         2013       2014        2013
       Net earnings                     $   50,786   $ 41,208    $ 23,480   $ 12,944
       Depreciation and amortization         7,461      8,388      15,122     17,034
       Interest expense                      6,096      6,088      11,706     11,930
       Income tax expense                    2,640      3,977       2,305      3,396


       EBITDA                           $   66,983   $ 59,661    $ 52,613   $ 45,304


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Results of Operations

    The following table sets forth certain financial information from our
unaudited consolidated statements of operations expressed as a percentage of
total revenues:

                                                Three Months         Six Months
                                                    Ended               Ended
                                                 January 31,         January 31,
                                               2014      2013      2014      2013
        Revenues                                100.0 %   100.0 %   100.0 %   100.0 %
        Cost of sales                            47.0      49.4      46.9      48.5


        Gross margin                             53.0      50.6      53.1      51.5
        Selling, general and administrative      42.7      41.6      47.9      47.2
        Depreciation and amortization             1.1       1.3       1.5       1.7
        Other charges (gains)                     0.1       0.1         -      (0.1 )


        Operating earnings                        9.1       7.6       3.7       2.7
        Interest expense                          0.9       0.9       1.1       1.2


        Earnings before income taxes              8.1       6.7       2.5       1.6
        Income tax expense                        0.4       0.6       0.2       0.3


        Net earnings                              7.7 %     6.1 %     2.3 %     1.3 %

Three Months Ended January 31, 2014 Compared to Three Months Ended January 31, 2013

Revenues. Revenues for the quarter ended January 31, 2014 were $656.4 million, a decrease of 2.1 percent compared to revenues of $670.8 million for the same period in the prior year. The decrease in revenues was the result of a $16.9 million decrease related to 86 store closures since January 31, 2013 (net of store openings) and an $8.2 million decrease related to the depreciation in the Canadian currency rate, partially offset by an increase in comparable store sales. Comparable store sales increased 0.6 percent during the second quarter of fiscal year 2014, or 1.9 percent at constant exchange rates. The increase in comparable store sales was primarily attributable to a 7.5 percent increase in the number of units sold in Fine Jewelry, partially offset by a decrease in the average price per unit.

Fine Jewelry contributed $580.8 million of revenues in the quarter ended January 31, 2014, a decrease of 1.6 percent compared to $590.1 million for the same period in the prior year.

Kiosk Jewelry contributed $72.8 million of revenues in the quarter ended January 31, 2014, a decrease of 6.5 percent compared to $77.9 million in the same period in the prior year. The decrease in revenues is due to a 5.2 percent decrease in the average price per unit, partially offset by an increase in the number of units sold. The decrease in revenues is also due to 20 kiosk closures since January 31, 2013 (net of openings).

All Other contributed $2.8 million in revenues for the three months ended January 31, 2014, an increase of 4.1 percent compared to $2.7 million for the same period in the prior year.

During the quarter ended January 31, 2014, we closed 22 stores in Fine Jewelry and two locations in Kiosk Jewelry. In addition, we opened two stores in Fine 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 53.0 percent of revenues for the quarter ended January 31, 2014, compared to 50.6 percent for the same period in the prior year. The 240 basis point improvement was due primarily to benefits realized from our sourcing initiative launched in fiscal year 2013, lower commodity costs and a more disciplined approach to our promotional programs.


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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 42.7 percent of revenues for the quarter ended January 31, 2014 compared to 41.6 percent for the same period in the prior year. SG&A increased by $1.1 million to $280.1 million for the quarter ended January 31, 2014. The increase is due to an $8.6 million increase in costs primarily related to higher labor and marketing costs, partially offset by the impact of 86 store closures since January 31, 2013 (net of store openings).

Depreciation and Amortization. Depreciation and amortization as a percentage of revenues for the quarters ended January 31, 2014 and 2013 was 1.1 percent and 1.3 percent, respectively. The decrease is primarily the result of 86 store closures (net of store openings), partially offset by additional capital expenditures.

Other Charges (Gains). Other charges for the quarters ended January 31, 2014 and 2013 consists of a $0.5 million and $0.9 million charge, respectively, related to the impairment of long-lived assets associated with underperforming stores.

Interest Expense. Interest expense remained flat at $6.1 million, or 0.9 percent of revenues, for the quarters ended January 31, 2014 and 2013.

Income Tax Expense. Income tax expense totaled $2.6 million for the three months ended January 31, 2014, as compared to $4.0 million for the same period in the prior year. Income tax expense for both periods was primarily associated with operating earnings related to our Canadian subsidiaries.

Six Months Ended January 31, 2014 Compared to Six Months Ended January 31, 2013

Revenues. Revenues for the six months ended January 31, 2014 were $1,019.1 million, a decrease of 0.9 percent compared to revenues of $1,028.2 million for the same period in the prior year. The decrease in revenues was the result of a $25.1 million decrease related to 86 store closures since January 31, 2013 (net of store openings) and an $11.4 million decrease related to the depreciation in the Canadian currency rate, partially offset by an increase in comparable store sales. Comparable store sales increased 1.9 percent during the six months ended January 31, 2014, or 3.0 percent at constant exchange rates. The increase in comparable store sales was primarily attributable to 7.7 percent increase in the number of units sold in Fine Jewelry, partially offset by a decrease in the average price per unit.

Fine Jewelry contributed $894.5 million of revenues in the six months ended January 31, 2014, a decrease of 0.3 percent compared to $897.1 million for the same period in the prior year.

Kiosk Jewelry contributed $119.0 million of revenues in the six months ended January 31, 2014, a decrease of 5.3 percent compared to $125.7 million in the same period in the prior year. The decrease in revenues is due to a 2.8 percent decrease in the average price per unit and a decrease in the number of units sold. The decrease in revenues is also due to 20 kiosk closures since January 31, 2013 (net of openings).

All Other contributed $5.5 million in revenues for the six months ended January 31, 2014, an increase of 2.6 percent compared to $5.4 million for the same period in the prior year.

During the six months ended January 31, 2014, we closed 29 stores in Fine Jewelry and seven locations in Kiosk Jewelry. In addition, we opened two stores in Fine 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 53.1 percent of revenues for the six months ended January 31, 2014, compared to 51.5 percent for the same period in the prior year. The 160 basis point improvement was due primarily to benefits realized from our sourcing initiative launched in fiscal year 2013, lower commodity costs and a more disciplined approach to our promotional programs.


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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 47.9 percent of revenues for the six months ended January 31, 2014 compared to 47.2 percent for the same period in the prior year. SG&A increased by $2.8 million to $488.3 million for the six months ended January 31, 2014. The increase is due to a $13.7 million increase in costs primarily related to higher labor, marketing and legal related costs, partially offset by the impact of 86 store closures since January 31, 2013 (net of store openings).

Depreciation and Amortization. Depreciation and amortization as a percentage of revenues for the six months ended January 31, 2014 and 2013 was 1.5 percent and 1.7 percent, respectively. The decrease is primarily the result of 86 store closures (net of store openings), partially offset by additional capital expenditures.

Other Charges (Gains). Other charges for the six months ended January 31, 2014 consists of a $0.5 million charge related to the impairment of long-lived assets associated with underperforming stores. Other gains for the six months ended January 31, 2013 includes proceeds totaling $1.9 million related to the De Beers settlement, partially offset by a $0.9 million charge related to the impairment of long-lived assets associated with underperforming stores.

Interest Expense. Interest expense as a percentage of revenues remained relatively flat at 1.1 percent for the six months ended January 31, 2014 compared to 1.2 percent for the same period in the prior year.

Income Tax Expense. Income tax expense totaled $2.3 million for the six months ended January 31, 2014, as compared to $3.4 million for the same period in the prior year. Income tax expense for both periods was primarily associated with operating earnings related to our Canadian subsidiaries.

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 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 January 31, 2014, we had borrowing availability under the revolving credit agreement of approximately $259 million. The average vendor payment terms during the six months ended January 31, 2014 and 2013 were approximately 46 days and 54 days, respectively. As of January 31, 2014, we had cash and cash equivalents totaling $23.3 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 used in operating activities improved from $12.8 million for the six months ended January 31, 2013 to $6.4 million for the six months ended January 31, 2014. The $6.4 million improvement is primarily the result of a $9.2 million increase in operating earnings.

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 January 31, 2014 was $864.3 million, an increase of $27.7 million compared to January 31, 2013. The increase is primarily due to the expansion of our exclusive, branded merchandise collections, partially offset by the impact of 86 store closures (net of store openings) since January 31, 2013.


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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 68 to 73 percent for the period of February through September 2014, 82 to 84 percent for the period of October through December 2014 and 71 percent for January 2015.

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.

If excess availability (as defined in the Amended Credit Agreement) falls below certain levels we will be required to maintain a minimum fixed charge coverage ratio of 1.0. Borrowing availability was approximately $259 million as of January 31, 2014, which exceeded the excess availability requirement by $197 million. The fixed charge coverage ratio was 2.47 as of January 31, 2014. The Amended Credit Agreement contains various other covenants including restrictions on the incurrence of certain indebtedness, payment of dividends, liens, investments, acquisitions and asset sales. As of January 31, 2014, we were in compliance with all covenants.

We incurred debt issuance costs associated with the revolving credit agreement totaling $12.1 million, which consisted of $5.6 million of costs related to the Amended Credit Agreement and $6.5 million of unamortized costs associated with the prior agreement. The debt issuance costs are included in other assets in the accompanying consolidated balance sheets and are amortized to interest expense on a straight-line basis over the five-year life of the agreement.

Interest Rate Swap Agreements

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 replaced the one-month LIBOR with the fixed interest rates shown in the table below and are settled monthly. The swaps qualify as cash flow hedges and, to the extent effective, changes in their fair values are recorded in accumulated other comprehensive income in the consolidated balance sheet. The changes in fair values are reclassified from accumulated other comprehensive income to interest expense in the same period that the hedged items affect interest expense.


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Interest rate swaps as of January 31, 2014 are as follows:

                               Notional Amount         Fixed           Fair Value
   Period                      (in thousands)      Interest Rate     (in thousands)
   October 2013 - July 2014    $        215,000              0.29 %   $          117
   August 2014 - July 2016     $        215,000              1.19 %            2,474


                                                                      $        2,591

The change in the fair value of the interest rate swaps for the three and six months ended January 31, 2014 totaled $0.1 million and $2.7 million, respectively, and is included as an unrealized loss in other comprehensive income. There were no material amounts reclassified from accumulated other comprehensive income to interest expense during the three and six months ended January 31, 2014. The current portion of the fair value of the interest rate swaps totaled $1.0 million and is included in accounts payable and accrued . . .

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