ZALE CORP – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

         º •         º achieved revenue growth of 7.1 percent, reaching $1.9 billion in           annual revenues;          º •         º delivered a 6.9 percent increase in comparable store sales, following           an 8.1 percent rise in fiscal year 2011, marking seven consecutive           quarters of positive results;          º •         º generated operating earnings of $19 million, a $47 million improvement           over the prior year and the first time we reported operating earnings           since fiscal year 2008;          º •         º improved the capital structure by refinancing our revolving credit           agreement and senior secured term loan which increased our borrowing           availability by approximately $50 million as of July 31, 2012,           decreased borrowing costs which will result in estimated interest           expense savings of approximately $17 million in fiscal year 2013 and           eliminated the store contribution covenants contained in the prior           term loan;          º •         º continued to build and strengthen our core merchandise assortment           reaching our goal of returning the core to approximately 85 percent of           our inventory mix, while beginning to introduce proprietary brands,           including the Vera Wang LOVE and Persona bead collections;          º •         º expanded 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;          º •         º implemented a program to provide alternative financing options to our           U.S. Fine Jewelry customers who do not qualify for financing through           our primary Citi credit program; and          º •         º increased organizational effectiveness by making deliberate,           thoughtful investments in people, functions and training. 

Warranties

Net earnings associated with warranties totaled $120.8 million for the year ended July 31, 2012, compared to $75.2 million for the same period in the prior year. The increase is primarily the result of improved sales and a $34.9 million increase resulting from a change in revenue recognition related to lifetime warranties. Accounting Standards Codification 605-20, Revenue Recognition-Services, requires recognition of warranty revenue on a straight-line basis until sufficient cost history exists. Once sufficient cost history is obtained, revenue is required to be recognized in proportion to when costs are expected to be incurred. Prior to fiscal year 2012, the Company recognized revenue from lifetime warranties on a straight-line basis over a five-year period because sufficient evidence of the pattern of costs incurred was not available. During the first quarter of fiscal year 2012, we began recognizing revenue in proportion to when the expected costs will be incurred, which we estimate will be over an eight-year period. The deferred revenue balance as of July 31, 2011 related to lifetime warranties is recognized prospectively in proportion to the remaining estimated warranty costs. The change in estimate related to the pattern of revenue recognition and the life of the warranties is the result of accumulating additional historical evidence over the five-year period that we have been selling the lifetime warranties.

Outlook for Fiscal Year 2013

We expect to generate positive net income in fiscal year 2013. We believe this will be achieved as a result of continued positive comparable store sales, maintaining gross margin rates consistent with fiscal year 2012, realizing leverage on selling, general and administrative expenses based on top line growth, while making selective investments in the business, and interest expense savings estimated at approximately $17 million as a result of the debt refinancing transactions completed on July 24, 2012. Total interest expense is expected to be between $23 million and $25 million in fiscal year 2013 compared to $44.6 million in fiscal year 2012, which includes $5 million of costs associated with the debt refinancing

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transactions. In addition, we expect the effective tax rate to be approximately 15 percent and store closures to be in-line with fiscal year 2012.

Comparable Store Sales

Comparable store sales include internet sales and repair sales and exclude revenue recognized from warranties and insurance premiums related to credit insurance policies sold to guests who purchase merchandise under our customer 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.

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 performance measure to assist us in explaining underlying performance trends in our business.

EBITDA is a non-GAAP financial measure and should not be considered in isolation of, or as a substitute for, net 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 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 loss from continuing operations as presented in our consolidated statements of operations:

                                                    Year Ended July 31,                                               2012         2011        2010           Loss from continuing operations   $ (26,896 ) $ (112,042 ) $ (95,790 )           Depreciation and amortization        37,887       41,326      50,005           Interest expense                     44,649       82,619      15,657           Income tax expense (benefit)          1,365        1,557     (28,750 )            EBITDA                            $  57,005   $   13,460   $ (58,878 )                                           23 

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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 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,                                                            2012       2011       2010 Revenues                                                    100.0 %    100.0 %    100.0 % Cost of sales                                                48.5       49.5       49.6  Gross margin                                                 51.5       50.5       50.4 Selling, general and administrative                          48.3       49.3       52.4 Depreciation and amortization                                 2.0        2.4        3.1 Other charges                                                 0.1        0.4        2.1  Operating earnings (loss)                                     1.0       (1.6 )     (7.1 ) Interest expense                                              2.4        4.7        1.0 Other gains                                                     -          -       (0.4 )  Loss before income taxes                                     (1.4 )     (6.3 )     (7.7 ) Income tax expense (benefit)                                  0.1        0.1       (1.8 )  Loss from continuing operations                              (1.5 )     (6.4 )     (5.9 ) (Loss) earnings from discontinued operations, net of taxes                                                           -          -        0.1  Net loss                                                     (1.5 )%    (6.4 )%    (5.8 )%   

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 for the same period in the prior fiscal year. Comparable store sales increased 6.9 percent as compared to the same period in 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 change in the number of units sold and the average price per unit includes the impact of an increase in sales related to our bead product lines, which are sold at a lower price point. The increase in revenue 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 for the same period in the prior year.

Kiosk Jewelry contributed $238.7 million of revenues in the fiscal year ended July 31, 2012 as compared to $239.2 million in the prior year, representing a decrease of 0.2 percent. 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.

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 for the same period 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.

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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 same period in 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 selling, general and administrative ("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 for the same period 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 same period in 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 for the same period in the prior year. Income tax expense for the year ended July 31, 2012 is primarily associated with earnings of 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 earnings of 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 (the "Business Assistance Act").

Year Ended July 31, 2011 Compared to Year Ended July 31, 2010

Revenues. Revenues for fiscal year 2011 were $1,742.6 million, an increase of 7.8 percent compared to revenues of $1,616.3 million for the same period in the prior fiscal year. Comparable store sales increased 8.1 percent as compared to the same period in the prior year. The increase in comparable store sales was attributable to an 8.1 percent increase in the average price per unit in our fine jewelry stores and a 0.5 percent increase in the number of units sold. The increase in revenue was also due to a $25.1 million

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increase in revenues recognized related to warranties, partially offset by a decrease in revenues related to 61 store closures (net of store openings) during fiscal year 2011.

Fine Jewelry contributed $1,493.3 million of revenues in the fiscal year ended July 31, 2011, an increase of 8.2 percent as compared to $1,379.7 million for the same period in the prior year.

Kiosk Jewelry contributed $239.2 million of revenues in the fiscal year ended July 31, 2011 as compared to $226.2 million in the prior year, representing an increase of 5.8 percent. The increase in revenue is primarily the result of a 1.6 percent increase in average price per unit and a 2.0 percent increase in the number of units sold.

All Other contributed $10.0 million in revenues for the fiscal year ended July 31, 2011 as compared to $10.4 million for the same period in the prior year, representing a decrease of 3.7 percent.

During the fiscal year ended July 31, 2011, we opened four stores in Fine Jewelry and seven locations in Kiosk Jewelry. In addition, we closed 59 stores in Fine Jewelry and 13 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 10 basis points to 50.5 percent for the fiscal year ended July 31, 2011 compared to the same period in the prior year. The increase in gross margin was due to a 100 basis point increase in revenues recognized related to warranties, a 110 basis point decrease in inventory impairment charges as a result of improved sales and lower merchandise discounts. The increase was partially offset by an increase in the cost of merchandise, including an $11.3 million increase in the LIFO inventory charge.

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 49.3 percent of revenues for the year ended July 31, 2011, compared to 52.4 percent for the same period in the prior year. SG&A increased by $13.4 million to $859.6 million for the year ended July 31, 2011. The increase is primarily the result of a $23.4 million increase in labor costs and store and corporate performance-based compensation associated with improved sales and a $5.7 million increase in credit card fees primarily due to increased sales in the U.S. The increase was partially offset by a $7.6 million decrease in professional fees and severance costs, a $5.8 million decrease related to fees paid to Citibank in fiscal year 2010 and a $3.2 million decrease in occupancy costs.

Depreciation and Amortization. Depreciation and amortization as a percent of revenues for the year ended July 31, 2011 and 2010 was 2.4 percent and 3.1 percent, respectively. The decrease is primarily the result of store closures and impairment charges recorded during fiscal years 2011 and 2010.

Other Charges. 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. Other charges for the year ended July 31, 2010 includes a $29.9 million charge related to the impairment of long-lived assets associated with underperforming stores and a $3.4 million charge associated with store closures.

Interest Expense. Interest expense as a percent of revenues for the years ended July 31, 2011 and 2010 was 4.7 percent and 1.0 percent, respectively. Interest expense increased by $67.0 million to $82.6 million for the year ended July 31, 2011. The increase is primarily the result of a $45.8 million charge associated with an amendment to the term loan on September 24, 2010. The remaining $21.2 million increase is due primarily to a $16.2 million increase in interest related to the term loan executed in May 2010 and an increase in the weighted-average effective interest rate associated with the revolving credit agreement to 3.7 percent as compared to 1.8 percent for the same period in the prior year.

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Other Gains. Other gains for the year ended July 31, 2010 includes an $8.3 million gain related to a decrease in the fair value of the warrants issued in connection with the term loan executed in May 2010 and a $1.7 million charge related to debt issuance costs attributable to the warrants.

Income Tax Expense (Benefit). Income tax expense totaled $1.6 million for the year ended July 31, 2011, compared to a $28.8 million income tax benefit for the year ended July 31, 2010. Income tax expense for the year ended July 31, 2011 is primarily associated with earnings of our Canadian subsidiaries, partially offset by the recognition of a $4.6 million tax refund associated with the Business Assistance Act. The income tax benefit for the year ended July 31, 2010 is primarily the result of the recognition of a $33.4 million refund associated with the Business Assistance Act, partially offset by tax expense primarily associated with 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 distribution facilities, and debt service. For fiscal year 2012, our cash requirements were 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 receipts and vendor payments. At July 31, 2012, we had borrowing availability under the revolving credit agreement of approximately $149 million. The average vendor payment terms during the year ended July 31, 2012 and 2011 was approximately 52 days and 46 days, respectively. As of July 31, 2012, we had cash and cash equivalents totaling $24.6 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 $46.9 million for the year ended July 31, 2011 to $36.9 million for the year ended July 31, 2012. The $10.0 million improvement is primarily the result of an increase in operating earnings compared to the same period in the prior year and a $15.2 million payment in the prior year related to an amendment to the term loan, partially offset by an increase in inventory and costs incurred related to the debt refinancing transactions completed in the fourth quarter of fiscal year 2012 totaling $5.0 million. The increase in inventory and refinancing costs represented approximately $33 million of the $36.9 million net usage of cash from operating activities as of July 31, 2012.

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, 2012 was $741.8 million, an increase of $21.0 million compared to July 31, 2011. The increase is primarily the result of additional merchandise purchased as a result of increased sales and higher merchandise cost.

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 new $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. The rate applied to the appraised liquidation value of eligible inventory was 87.5 percent in the prior agreement. 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

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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 70 percent for the period of August through September 2012, 80 to 83 percent for the period of October through December 2012, and 67 to 72 percent for the period of January through July 2013.

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. The unused commitment fee was 50 basis points in the prior agreement.

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 $149 million as of July 31, 2012, which exceeded the excess availability requirement by $98 million. The fixed charge coverage ratio was 1.56 as of July 31, 2012. The Amended Credit Agreement contains various other covenants including restrictions on the incurrence of certain indebtedness, liens, investments, acquisitions and asset sales. As of July 31, 2012, we were in compliance with all covenants.

We incurred debt issuance costs associated with the revolving credit agreement totaling $12.1 million, which consists 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 will be amortized to interest expense on a straight-line basis over the five-year life of the agreement.

Amended and Restated Senior Secured Term Loan

On July 24, 2012, we amended and restated our senior secured term loan (the "Amended Term Loan") with Z Investment Holdings, LLC, an affiliate of Golden Gate Capital. The additional availability obtained under the Amended Credit Agreement (see below) was utilized to prepay $60.5 million of the prior term loan. The Amended Term Loan totals $80.0 million, matures in July 2017 and is subject to a borrowing base equal to: (i) 107.5 percent of the appraised liquidation value of eligible inventory plus (ii) 100 percent of credit card receivables and an amount equal to the lesser of $40 million or 100 percent of the appraised liquidation value of intellectual property minus (iii) the borrowing base under the Amended Credit Agreement. In the event the outstanding principal under the Amended Term Loan exceeds the Amended Term Loan borrowing base, availability under the Amended Credit Agreement would be reduced by the excess. As of July 31, 2012, the outstanding principal under the Amended Term Loan did not exceed the borrowing base. The improved minimum liquidity requirement under the Amended Term Loan increased borrowing availability under the Amended Credit Agreement by approximately $50 million as of July 31, 2012. The Amended Term Loan is secured by a second priority security interest on merchandise inventory and credit card receivables and a first priority security interest on substantially all other assets.

Borrowings under the Amended Term Loan bear interest at 11 percent payable on a quarterly basis. The interest rate under the prior term loan was 15 percent. We may repay all or any portion of the Amended Term Loan with the following penalty prior to maturity: (i) the present value of the required interest payments that would have been made if the prepayment had not occurred during the first year; (ii) 4 percent during the second year; (iii) 3 percent during the third year; (iv) 2 percent during the fourth year and (v) no penalty in the fifth year. The Amended Credit Agreement restricts our ability to prepay the

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Amended Term Loan prior to January 15, 2013 and, subsequent to this date, if the fixed charge coverage ratio is not equal to or greater than 1.0 after giving effect to the prepayment.

The Amended Term Loan includes various covenants which are consistent with the covenants in the Amended Credit Agreement, including restrictions on the incurrence of certain indebtedness, liens, investments, acquisitions, asset sales and the requirement to maintain a minimum fixed charge coverage ratio of 1.0 if excess availability thresholds under the Amended Credit Agreement are not maintained. The Amended Term Loan does not contain any of the store contribution covenants that were included in the prior term loan. As of July 31, 2012, we were in compliance with all covenants.

We incurred costs associated with the Amended Term Loan totaling $4.4 million, of which approximately $2 million was recorded in interest expense during the fourth quarter of fiscal year 2012. The remaining $2.4 million consists of debt issuance costs included in other assets in the accompanying balance sheet and are amortized to interest expense on a straight-line basis over the five-year life of the agreement. We also incurred a $3.0 million prepayment premium related to the $60.5 million prepayment of the prior term loan. The $3.0 million prepayment premium was recorded in interest expense during the fourth quarter of fiscal year 2012.

Warrant and Registration Rights Agreement

In connection with the execution of the senior secured term loan in May 2010, we entered into a Warrant and Registration Rights Agreement (the "Warrant Agreement") with Z Investment Holdings, LLC. Under the terms of the Warrant Agreement, we issued 6.4 million A-Warrants and 4.7 million B-Warrants (collectively, the "Warrants") to purchase shares of our common stock, on a one-for-one basis, for an exercise price of $2.00 per share. The Warrants, which are currently exercisable and expire seven years after issuance, represented 25 percent of our common stock on a fully diluted basis (including the shares issuable upon exercise of the Warrants and excluding certain out-of-the-money stock options) as of the date of the issuance. The A-Warrants were exercisable immediately; however, the B-Warrants were not exercisable until the shares of common stock to be issued upon exercise of the B-Warrants were approved by our stockholders, which occurred on July 23, 2010. The number of shares and exercise price are subject to customary antidilution protection. The Warrant Agreement also entitles the holder to designate two, and in certain circumstances three, directors to our board. The holders of the Warrants may, at their option, request that we register for resale all or part of the common stock issuable under the Warrant Agreement.

The fair value of the Warrants totaled $21.3 million as of the date of issuance and was recorded as a long-term liability, with a corresponding discount to the carrying value of the prior term loan. On July 23, 2010, the stockholders approved the shares of common stock to be issued upon exercise of the B-Warrants. The long-term liability associated with the Warrants was marked-to-market as of the date of the stockholder approval resulting in an $8.3 million gain during the fourth quarter of fiscal year 2010. The remaining amount of $13.0 million was reclassified to stockholders' investment and is included in additional paid-in capital in the accompanying consolidated balance sheet. As indicated above, the remaining unamortized discount totaling $20.3 million associated with the Warrants was charged to interest expense as a result of an amendment to the prior term loan on September 24, 2010.

Capital Lease Obligations

In fiscal year 2012, we entered into capital leases related to vehicles for our field management. The vehicles are included in property and equipment in the accompanying consolidated balance sheet and are depreciated over a four-year life. The amount capitalized during the year ended July 31, 2012 totaled $3.6 million; such amount is a non-cash item and therefore excluded from the consolidated statement of cash flows.

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  Table of Contents       Customer Credit Programs 

On September 23, 2010, we entered into a five year agreement to amend and restate various terms of the Merchant Services Agreement ("MSA") with Citibank (South Dakota), N.A. ("Citibank"), to provide financing for our U.S. guests to purchase merchandise through private label credit cards beginning October 1, 2010. The MSA will automatically renew for successive two-year periods, unless either party notifies the other in writing of its intent not to renew. In addition, the MSA can be terminated by either party upon certain breaches by the other party and also can be terminated by Citibank if our net credit card sales during any twelve-month period are less than $315 million or if net card sales during a twelve-month period decrease by 20 percent or more from the prior twelve-month period. After any termination, we may purchase or be obligated to purchase the credit card portfolio upon termination with Citibank as a result of insolvency, material breaches of the MSA and violations of applicable law related to the credit card program. As of July 31, 2012, we were in compliance with all covenants under the MSA. We exceeded the $315 million threshold for the program year ending September 30, 2012. During fiscal year 2012 and 2011, our guests used our private label credit card to pay for approximately 35 percent and 32 percent, respectively, of purchases in the U.S.

On May 7, 2010, we entered into a five year Private Label Credit Card Program Agreement (the "TD Agreement") with TD Financing Services Inc. ("TDFS") to provide financing for our Canadian guests to purchase merchandise through private label credit cards beginning July 1, 2010. In addition, TDFS provides credit insurance for our guests and will receive 40 percent of the net profits, as defined, and the remaining 60 percent paid to us. The TD Agreement replaced an agreement with Citi Cards Canada Inc., which expired on June 30, 2010. The TD Agreement will automatically renew for successive one-year periods, unless either party notifies the other in writing of its intent not to renew. The agreement may be terminated at any time during the 90-day period following the end of a program year in the event that credit sales are less than $50 million in the immediately preceding year. If TDFS terminates the agreement as a result of a breach by us, we will be required to pay a termination fee of $1.0 million in the first year, $0.7 million in the second year or $0.3 million in the third year. As of July 31, 2012, credit sales exceeded the $50 million threshold for the program year ending June 30, 2012. During fiscal year 2012 and 2011, our guests used our private label credit card to pay for approximately 19 percent and 21 percent, respectively, of purchases in Canada.

Citibank.

Capital Expenditures

During fiscal year 2012, we invested $12.8 million to remodel, relocate and refurbish 40 Fine Jewelry stores. We invested $1.1 million in capital expenditures to convert nine Gordon's stores to the Zales nameplate, one Zales store to the Zales Outlet nameplate and to open two stores in Kiosk Jewelry. We also invested $5.9 million in infrastructure, primarily related to information technology and the U.S. distribution center. We anticipate investing between $30 million and $35 million in capital expenditures in fiscal year 2013.

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Contractual Obligations

Aggregate information about our contractual obligations as of July 31, 2012 is presented in the following table (in thousands):

                                               Payments Due by Period                                Less than                                     More than                     Total        1 Year      1 - 3 Years     4 - 5 Years      5 Years      Other Long-term debt (excluding capital leases)          $   449,800    $       -    $          -    $    449,800    $        -   $     - Interest on Amended Term Loan(a)               43,829        8,800          17,600          17,429             -         - Capital lease obligations            3,108          880           1,859             369             -         - 

Operating

 leases(b)            623,628      164,430         240,571         137,420        81,207         - 

Operations

services

 agreement(c)          28,626        7,417          14,238           6,971             -         - 

Other

long-term

 liabilities(d)         5,527            -               -               -             -     5,527  Total            $ 1,154,518    $ 181,527    $    274,268    $    611,989    $   81,207   $ 5,527    

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   º (a)    º The Amended Term Loan requires fixed quarterly interest payments at      11 percent per annum on the outstanding principal balance. This amount does      not reflect any interest related to the Amended Credit Agreement, which      would be based on the current applicable rate and assumes no prepayments.      The effective interest rate of the Amended Credit Agreement was 4.0 percent      as of July 31, 2012. In fiscal year 2012, we paid $14.3 million of interest      related to our revolving credit agreement.     º (b)    º Operating lease obligations relate to minimum base rental payments due      under store lease agreements. Excluded from our operating lease commitments      are amounts related to real estate taxes, insurance, common area      maintenance fees and merchant association dues. Such amounts were      approximately 22 percent of base rentals for the year ended July 31, 2012.     º (c)    º The operations services agreement is with a third party for the management      of our client server systems, Local Area Network operations, Wide Area      Network management and technical support.     º (d)    º Other long-term liabilities reflect loss reserves related to credit      insurance services provided by our insurance subsidiaries. We have      reflected these payments under "Other," as the timing of these future      payments is dependent on the actual processing of the claims. 

Not included in the table above are our obligations under employment agreements and ordinary course purchase orders for merchandise, including certain merchandise on consignment.

Recent Accounting Pronouncement

In May 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs ("ASU 2011-04"). ASU 2011-04 amends ASC 820, Fair Value Measurements and Disclosures, to improve comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and International Financial Reporting Standards. The amendment is effective during interim and annual periods beginning after December 15, 2011. We adopted this standard effective February 1, 2012. There was not a material impact from the adoption of this guidance on our consolidated financial statements.

In June 2011, the FASB issued Accounting Standards Update 2011-05, Presentation of Comprehensive Income ("ASU 2011-05"). ASU 2011-05 eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendment will instead require that all nonowner changes in stockholders' equity be presented either in a single continuous statement, referred to as the statement of comprehensive income, or in two separate but consecutive statements. The amendment is effective for fiscal years beginning after December 15, 2011. We

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do not expect a material impact from the adoption of this guidance on our consolidated financial statements.

In August 2011, the FASB issued Accounting Standards Update 2011-08, Intangibles-Goodwill and Other ("ASU 2011-08"), which will simplify the rules for testing goodwill for impairment. ASU 2011-08 will allow entities to make a qualitative evaluation about the likelihood of goodwill impairment to determine whether a company should perform the two-step impairment test as required under ASC 350, Intangibles-Goodwill and Other. The amendment is effective for goodwill impairment tests performed for fiscal years beginning after December 15, 2011. We do not expect a material impact from the adoption of this guidance on our consolidated financial statements.

Off-Balance Sheet Arrangements

We have no material off-balance sheet arrangements as of July 31, 2012.

Critical Accounting Policies and Estimates

Our significant accounting policies are disclosed in Note 1 of our consolidated financial statements. The following discussion addresses our most critical accounting policies, which are those that are both important to the portrayal of our financial condition and results of operations and that require significant judgment or use of complex estimates.

Merchandise Inventories. Merchandise inventories are stated at the lower of cost or market. Substantially all U.S. inventories represent finished goods which are valued using the LIFO retail inventory method. Merchandise inventory of our Canadian brands, Peoples and Mappins, is valued using the retail inventory method. Under the retail method, inventory is segregated into categories of merchandise with similar characteristics at its current average retail selling value. The determination of inventory cost and the resulting gross margins are calculated by applying an average cost-to-retail ratio to the retail value of inventory. At the end of fiscal year 2012, approximately three percent and 13 percent of our total inventory represented raw materials and work in process related to our manufacturing program and finished goods in our distribution center, respectively. The inventory related to our manufacturing program and distribution center is valued at the weighted-average cost of the items.

We are required to determine the LIFO cost on an interim basis by estimating annual inflation trends, annual purchases and ending inventory levels for the fiscal year. Actual annual inflation rates and inventory balances as of the end of any fiscal year may differ from interim estimates. We apply internally developed indices that we believe accurately and consistently measure inflation or deflation in the components of our merchandise (i.e., the proper weighting of diamonds, gold and other metals and precious stones) and our overall merchandise mix. We believe our internally developed indices more accurately reflect inflation or deflation in our own prices than the U.S. Bureau of Labor Statistics producer price indices or other published indices.

We also reduce the carrying value of our inventory for discontinued, slow-moving and damaged inventory. This write-down of inventory is equal to the difference between the cost of inventory and its estimated market value based upon assumptions of targeted inventory turn rates, future demand, management strategy and market conditions. If actual market conditions are less favorable than those projected by management, or if management strategy changes, additional inventory write-downs may be required and, in the case of a major change in strategy or downturn in market conditions, such write-downs could be significant.

Shrinkage is estimated for the period from the last inventory date to the end of the fiscal year on a store-by-store basis. Such estimates are based on experience and the shrinkage results from the last physical inventory. Physical inventories are taken at least once annually for all store locations and the distribution centers. The shrinkage rate from the most recent physical inventory, in combination with

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historical experience and significant changes in physical inventory results, could impact our shrinkage reserve.

Impairment of Long-Lived Assets. Long-lived assets are periodically reviewed for impairment by comparing the carrying value of the assets with their estimated undiscounted future cash flows. If the evaluation indicates that the carrying amount of the asset may not be recoverable, the potential impairment is measured based on a projected discounted cash flow method, using a discount rate that is considered to be commensurate with the risk inherent in our current business model. Assumptions are made with respect to cash flows expected to be generated by the related assets based upon the most recent projections. Any changes in key assumptions, particularly store performance or market conditions, could result in an unanticipated impairment charge. For instance, in the event of a major market downturn or adverse developments within a particular market or portion of our business, individual stores may become unprofitable, which could result in a write-down of the carrying value of the assets in those stores. Any impairment would be recognized in operating results.

Goodwill. In accordance with ASC 350, Intangibles-Goodwill and Other, we test goodwill for impairment annually, at the end of our second quarter, or more frequently if events occur which indicate a potential reduction in the fair value of a reporting unit's net assets below its carrying value. We calculate estimated fair value using the present value of future cash flows expected to be generated using a weighted-average cost of capital, terminal values and updated financial projections. As of the date of the most recent test, the fair value of the Peoples and Piercing Pagoda reporting units would have to decline by more than 22 percent and 52 percent, respectively, to be considered for impairment. If our actual results are not consistent with estimates and assumptions used to calculate fair value, we may be required to recognize a goodwill impairment.

Revenue Recognition. We recognize revenue in accordance with ASC 605, Revenue Recognition. Revenue related to merchandise sales, which is approximately 89 percent of total revenues, is recognized at the time of sale, reduced by a provision for sales returns. The provision for sales returns is based on historical rates of return. Repair revenues are recognized when the service is complete and the merchandise is delivered to the guest. Premium revenues from our insurance businesses relate to credit insurance policies sold to guests who purchase our merchandise under the customer credit program. Insurance premiums are recognized over the coverage period.

We offer our Fine Jewelry guests lifetime warranties on certain products that cover sizing and breakage with an option to purchase theft protection for a two-year period. ASC 605-20, Revenue Recognition-Services, requires recognition of warranty revenue on a straight-line basis until sufficient cost history exists. Once sufficient cost history is obtained, revenue is required to be recognized in proportion to when costs are expected to be incurred. Prior to fiscal year 2012, the Company recognized revenue from lifetime warranties on a straight-line basis over a five-year period because sufficient evidence of the pattern of costs incurred was not available. During the first quarter of fiscal year 2012, we began recognizing revenue related to lifetime warranty sales in proportion to when the expected costs will be incurred, which we estimate will be over an eight-year period. The deferred revenue balance as of July 31, 2011 related to lifetime warranties is recognized prospectively, in proportion to the remaining estimated warranty costs. The change in estimate related to the pattern of revenue recognition and the life of the warranties is the result of accumulating additional historical evidence over the five-year period that we have been selling the lifetime warranties. The change in estimate increased revenues by $34.9 million and improved our net loss by $32.4 million during fiscal year 2012. As a result, basic and diluted net loss per share improved by $1.00 per share during fiscal year 2012.

Revenues related to the optional theft protection are recognized over the two-year contract period on a straight-line basis. We also offer our Fine Jewelry guests a two-year watch warranty and our Fine Jewelry and Kiosk Jewelry guests a one-year warranty that covers breakage. The revenue from the two-year watch

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warranty and one-year breakage warranty is recognized on a straight-line basis over their respective contract terms.

Self-Insurance. We are self-insured for certain losses related to property insurance, general liability, workers' compensation and medical claims. Our liability represents an estimate of the ultimate cost of claims incurred as of the balance sheet dates. The estimated liability is not discounted and is established based upon analysis of historical data and actuarial estimates. While we believe these estimates are reasonable based on the information currently available, if actual trends, including the severity or frequency of claims, medical cost inflation, or fluctuations in premiums differ from our estimates, our results of operations could be impacted.

Other Reserves. We are involved in a number of legal and governmental proceedings as part of the normal course of business. Reserves are established based on management's best estimates of our potential liability in these matters. These estimates have been developed in consultation with in-house and outside counsel and are based on a combination of litigation and settlement strategies. In addition, from time to time we close stores prior to the expiration of the lease term. We record reserves associated with such leases based on the present value of the remaining lease rentals, including common area maintenance and other charges, reduced by estimated sublease rentals that could reasonably be obtained. If our estimates and assumptions used to record these charges change, we may be required to record additional charges.

Income taxes are estimated for each jurisdiction in which we operate. This involves assessing the current tax exposure together with temporary differences resulting from differing treatment of items for tax and financial statement accounting purposes. Any resulting deferred tax assets are evaluated for recoverability based on estimated future taxable income. To the extent that recovery is deemed not likely, a valuation allowance is recorded.

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