ZALE CORP – 10-Q – 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), 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, 2011.

   Overview   

We are a leading specialty retailer of fine jewelry in North America. At October 31, 2011, we operated 1,156 fine jewelry stores and 665 kiosk locations primarily in shopping malls throughout the United States of America, Canada and Puerto Rico.

We report our business under three operating segments: Fine Jewelry, Kiosk Jewelry and All Other. Fine Jewelry is comprised of five brands, Zales Jewelers®, Zales Outlet®, Gordon's Jewelers®, Peoples Jewellers® and Mappins Jewellers®, and is predominantly focused on the value-oriented consumer. 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 customer. 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 customers.

Comparable store sales increased by 5.8 percent during the first quarter of fiscal year 2012. At constant exchange rates, which excludes the effect of translating Canadian currency denominated sales into U.S. dollars, comparable store sales increased by 5.2 percent for the quarter. Gross margin increased by 300 basis points to 53.5 percent during the first quarter of fiscal year 2012 compared to the same period in the prior year. The increase in gross margin was partially due to an 85 basis point increase resulting from a change in warranty revenue recognition. The remaining 215 basis point improvement was the result of lower merchandise discounts and an increase in retail prices, partially offset by an increase in the cost of merchandise. Operating loss for the quarter was $22.5 million compared to an operating loss of $42.0 million in the same period in the prior year, an improvement of $19.5 million. Operating margin improved by 640 basis points to negative 6.4 percent compared to negative 12.8 percent in the same period in the prior year. The improvement in operating margin is primarily the result of greater operating leverage and an increase in gross margin.

Net earnings associated with warranties totaled $27.9 million for the three months ended October 31, 2011, compared to $16.5 million for the same period in the prior year. The increase is primarily the result of improved sales and a $6.3 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. The Company has historically 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 will be 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.

During the three months ended October 31, 2011 and 2010, the average Canadian currency rate appreciated by approximately three percent and four percent, respectively, relative to the U.S. dollar as compared to the prior year period. The appreciation in the Canadian currency rate for the three months ended October 31, 2011 resulted in a $1.8 million increase in reported revenues, offset by an increase in both reported cost of sales and selling, general and administrative expenses of $0.8 million. The appreciation in the Canadian currency rate for the three months ended October 31, 2010 resulted in a $2.2 million increase in reported revenues, offset by an increase in reported cost of sales and selling, general and administrative expenses of $1.1 million and $1.0 million, respectively.

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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 customers 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.

   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 Ended                                                        October 31,                                                     2011         2010 Revenues                                             100.0 %      100.0 % Cost of sales                                         46.5         49.5 Gross margin                                          53.5         50.5 Selling, general and administrative                   56.9         59.7 Depreciation and amortization                          2.8          3.3 Other charges                                          0.1          0.3 Operating loss                                        (6.4 )      (12.8 ) Interest expense                                       2.8         16.9 Loss before income taxes                              (9.2 )      (29.7 ) Income tax benefit                                    (0.2 )          - Loss from continuing operations                       (9.0 )      (29.7 ) 

Loss from discontinued operations, net of taxes (0.1 ) (0.2 ) Net loss

                                              (9.1 )%     (29.9 )%     

Three Months Ended October 31, 2011 Compared to Three Months Ended October 31, 2010

Revenues. Revenues for the quarter ended October 31, 2011 were $351.0 million, an increase of 7.3 percent compared to revenues of $327.0 million for the same period in the prior year. Comparable store sales increased 5.8 percent as compared to the same period in the prior year. The increase in comparable store sales was attributable to a 13.5 percent increase in the average price per unit in our fine jewelry stores, partially offset by a 6.2 percent decrease in the number of units sold. The increase in revenue was also due to a $12.2 million increase in revenues related to warranties, of which $6.3 million is the result of a change in revenue recognition related to lifetime warranties, and a $1.8 million increase related to the appreciation of the Canadian currency rate. The increase was partially offset by a decrease in revenues related to 70 stores closed (net of store openings) since October 31, 2010.

Fine Jewelry contributed $300.7 million of revenues in the quarter ended October 31, 2011, an increase of 8.3 percent compared to $277.7 million for the same period in the prior year.

Kiosk Jewelry contributed $46.7 million of revenues for the quarter ended October 31, 2011 as compared to $46.4 million in the prior year, representing an increase of 0.6 percent. The increase in revenues is due to a 7.8 percent increase in the average price per unit offset by a 9.0 percent decrease in the number of units sold.

All Other contributed $3.6 million in revenues for the quarter ended October 31, 2011, an increase of 24.9 percent compared to $2.9 million for the same period in the prior year.

During the quarter ended October 31, 2011, we opened one location in Kiosk Jewelry. In addition, we closed seven stores in Fine Jewelry and two locations in Kiosk Jewelry.

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Gross Margin. Gross margin is net sales less cost of sales. Cost of sales includes cost related to merchandise sold, receiving and distribution, customer repairs and repairs associated with warranties. Gross margin was 53.5 percent of revenues for the quarter ended October 31, 2011, compared to 50.5 percent for the same period in the prior year. The 300 basis point increase was partially due to an 85 basis point increase resulting from a change in warranty revenue recognition. The remaining 215 basis point improvement was the result of lower merchandise discounts and an increase in retail prices, partially offset by an increase in the cost of merchandise.

Selling, General and Administrative. Included in selling, general and administrative expenses ("SG&A") are store operating, advertising, buying, cost of insurance operations and general corporate overhead expenses. SG&A was 56.9 percent of revenues for the quarter ended October 31, 2011, compared to 59.7 percent for the same period in the prior year. The 280 basis point improvement was primarily the result of greater operating leverage. SG&A increased by $4.6 million to $199.8 million for the quarter ended October 31, 2011. The increase is primarily the result of a $4.4 million increase in labor costs to support increased sales and a $1.5 million increase in promotional costs. The increase was partially offset by a $1.4 million decrease in occupancy costs primarily related to 70 stores closed (net of store openings) since October 31, 2010.

Depreciation and Amortization. Depreciation and amortization as a percentage of revenues for the quarter ended October 31, 2011 and 2010 was 2.8 percent and 3.3 percent, respectively. The decrease is primarily the result of store closures and impairment charges recorded during fiscal year 2011.

Other Charges. Other charges for the quarter ended October 31, 2011 and 2010 includes lease charges related to closed stores totaling $0.5 million and $1.1 million, respectively.

Interest Expense. Interest expense as a percentage of revenues for the quarters ended October 31, 2011 and 2010 was 2.8 percent and 16.9 percent, respectively. Interest expense decreased by $45.4 million to $9.9 million for the three months ended October 31, 2011. The decrease is the result of a $45.8 million charge recorded in the first quarter of fiscal year 2011 associated with the first amendment to our Senior Secured Term Loan ("Term Loan") on September 24, 2010.

Income Tax Benefit. Income tax benefit totaled $0.7 million for the three months ended October 31, 2011, as compared to $0.1 million for the same period in the prior year. Income tax benefits for both periods were primarily associated with operating losses 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 distribution facilities, and debt service. Through October 31, 2011, 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 purchases and vendor payments. The average vendor payment terms during the three months ended October 31, 2011 and 2010 was approximately 48 days and 42 days, respectively. As of October 31, 2011, we had cash and cash equivalents totaling $30.1 million.

Net cash used in operating activities improved from $127.3 million for the three months ended October 31, 2010 to $95.2 million for the three months ended October 31, 2011. The $32.1 million improvement in the deficit is primarily the result of a $19.5 million decrease in operating losses and a $15.2 million payment in the prior year related to the Term Loan amendment.

Our business is highly seasonal, with a disproportionate amount of sales (approximately 30 to 40 percent) occurring in November and December of each year, the Holiday season. Other important 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. Owned inventory at October 31, 2011 was $856.9 million, an increase of $22.6 million compared to inventory levels at October 31, 2010. The increase is primarily the result of additional merchandise purchased as a result of increased sales, higher merchandise cost and an increase in the Canadian exchange rate.

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Amended and Restated Revolving Credit Agreement

On May 10, 2010, we entered into an agreement to amend and restate various terms of the revolving credit agreement with Bank of America, N.A. and certain other lenders. The Amended and Restated Revolving Credit Agreement (the "Revolving Credit Agreement") consisted of two tranches: (a) an extended tranche totaling $530 million, including seasonal borrowings of $88 million, maturing on April 30, 2014 and (b) a non-extending tranche totaling $120 million, including seasonal borrowings of $20 million, maturing on August 11, 2011. The commitments under the agreement from both tranches total $650 million, including seasonal borrowings of $108 million. On April 21, 2011, the $120 million non-extending tranche was assigned to other lenders and the maturity date was extended to April 30, 2014, the maturity date for the remainder of the credit facility. Borrowings under the Revolving Credit Agreement are capped at the lesser of: (1) 73 percent of the cost of eligible inventory during October through December and 69 percent for the remainder of the year (less certain reserves that may be established under the agreement), plus 85 percent of eligible credit card receivables or (2) 87.5 percent of the appraised liquidation value of eligible inventory (less certain reserves that may be established under the agreement), plus 85 percent of eligible credit card receivables. The Revolving Credit Agreement also contains an accordion feature that allows us to permanently increase commitments up to an additional $100 million, subject to approval by our lenders and certain other requirements. The Revolving 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. At October 31, 2011, we had borrowing availability under the Revolving Credit Agreement of $206.5 million.

The monthly borrowing rates calculated from the cost of eligible inventory are as follows: 73 percent for November and December 2011; ranging from 63 to 67 percent for the period of January through September 2012 and 73 percent for October 2012.

Borrowings under the Revolving Credit Agreement bear interest at either: (i) LIBOR plus the applicable margin (ranging from 350 to 400 basis points) or (ii) the base rate (as defined in the Revolving Credit Agreement) plus the applicable margin (ranging from 250 to 300 basis points). We are required to pay a quarterly unused commitment fee of 50 basis points based on the preceding quarter's unused commitment.

Borrowing availability cannot be less than $40 million during the term of the agreement and less than $50 million on one occasion for three consecutive business days in each four-month period, except for the period from September 1 through November 30, when borrowing availability can be less than $50 million on two occasions, but in no event can borrowing availability be less than $50 million more than four times during any 12 consecutive months. Borrowing availability, excluding the $50 million minimum availability requirement, was approximately $157 million as of October 31, 2011. The Revolving Credit Agreement contains various other covenants including restrictions on the incurrence of certain indebtedness, liens, investments, acquisitions and asset sales. As of October 31, 2011, we were in compliance with all covenants under the Revolving Credit Agreement.

We incurred debt issuance costs associated with the Revolving Credit Agreement totaling $14.1 million, including $1.1 million associated with the April 21, 2011 extension of the $120 million portion of the credit facility. 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 four-year life of the Revolving Credit Agreement.

   Senior Secured Term Loan   

On May 10, 2010, we entered into a $150 million Senior Secured Term Loan (the "Term Loan") and a Warrant and Registration Rights Agreement (as discussed below) with Z Investment Holdings, LLC, an affiliate of Golden Gate Capital. The Term Loan matures on May 10, 2015 and is secured by a first priority security interest in substantially all current and future intangible assets not secured under the Revolving Credit Agreement and a second priority security interest on merchandise inventory, credit card receivables and certain other assets. The proceeds received were used to pay down amounts outstanding under the Revolving Credit Agreement after payment of debt issuance costs incurred pursuant to the Revolving Credit Agreement and the Term Loan. Debt issuance costs associated with the Term Loan totaled approximately $13.0 million, $1.7 million of which was attributable to the warrants issued in connection with the Term Loan (see more details below under Warrant and Registration Rights Agreement) and expensed on the date of issuance.

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On September 24, 2010, we amended the Term Loan with Z Investment Holdings, LLC. The amendment eliminated the Minimum Consolidated EBITDA covenant and our option to pay a portion of future interest payments in kind subsequent to July 31, 2010. As a result, all future interest payments will be made in cash. In consideration for the amendment, we paid Z Investment Holdings, LLC an aggregate of $25.0 million, of which $11.3 million was used to pay down the outstanding principal balance of the Term Loan, $1.2 million was a prepayment premium and $12.5 million was an amendment fee. The outstanding balance of the Term Loan after the amendment totaled $140.5 million. In accordance with Accounting Standards Codification ("ASC") 470-50, Debt-Modifications and Extinguishments, the amendment was considered a significant modification, which required us to account for the Term Loan and related unamortized costs as an extinguishment and record the amended Term Loan at fair value. As a result, we recorded a charge to interest expense totaling $45.8 million in the first quarter of fiscal year 2011. The charge consists of $20.3 million related to the unamortized discount associated with the warrants issued in connection with the Term Loan, the $12.5 million amendment fee, $10.3 million related to the unamortized debt issuance costs associated with the Term Loan and $2.7 million related to the prepayment premium and other costs associated with the amendment.

The Term Loan bears interest at 15 percent payable on a quarterly basis. We may repay all or any portion of the Term Loan with the following penalty prior to maturity: (i) 10 percent during the first year; (ii) 7.5 percent during the second year; (iii) 5.0 percent during the third year; (iv) 2.5 percent during the fourth year and (v) no penalty in the fifth year. Our ability to repay the Term Loan prior to maturity is restricted by certain conditions under the Revolving Credit Agreement, including a fixed charge coverage ratio that we currently do not meet.

The Term Loan contains various covenants, as defined in the agreement, including maintaining minimum store contribution thresholds for Piercing Pagoda and Zale Canada, as defined, and restrictions on the incurrence of certain indebtedness, liens, investments, acquisitions and asset sales. The Piercing Pagoda and Zale Canada minimum store contribution threshold for the twelve-month period ended October 31, 2011 is $21 million and CAD $31 million, respectively. As of October 31, 2011, store contribution for Piercing Pagoda and Zale Canada would have to decline by more than 35 percent and 32 percent, respectively, to breach these covenants. The Piercing Pagoda minimum store contribution thresholds for the remainder of fiscal year 2012 range from $22 million to $26 million. The Zale Canada minimum store contribution thresholds for the remainder of fiscal year 2012 range from CAD $33 million to CAD $36 million. Liquidity (as defined in the Term Loan) was $297.5 million as of October 31, 2011, which exceeded the $135 million minimum liquidity requirement under the Term Loan by $162.5 million. As of October 31, 2011, we were in compliance with all covenants under the Term Loan.

Warrant and Registration Rights Agreement

In connection with the execution of the 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 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. Issuance costs attributable to the Warrants totaling $1.7 million were expensed on the date of issuance. As indicated above, the remaining unamortized discount as of September 24, 2010 totaling $20.3 million associated with the Warrants was charged to interest expense during the first quarter of fiscal year 2011.

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Private Label Credit Card Programs

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 customers to purchase merchandise through private label credit cards beginning July 1, 2010. In addition, TDFS provides credit insurance for our customers and receives 40 percent of the net profits, as defined, and the remaining 60 percent is paid to us. The TD Agreement replaced the 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 October 31, 2011, we expect to exceed the $50 million threshold for the program year ending June 30, 2012. Our customers use our private label credit card to pay for approximately 21 percent of purchases in Canada.

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. customers 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. We may 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 October 31, 2011, we were in compliance with all covenants under the MSA. Beginning October 1, 2011, we are required to meet the net credit card sales threshold of $315 million. As of October 31, 2011, we expect to exceed the $315 million threshold for the program year ending September 30, 2012. Our customers use our private label credit card to pay for approximately 37 percent of purchases in the U.S.

In August 2011, we entered into an agreement with Monterey Financial Services, Inc. to provide alternative financing options to our U.S. customers who have been declined by Citibank.

   Capital Expenditures   

During the three months ended October 31, 2011, we invested $3.2 million to remodel, relocate and refurbish nine stores in Fine Jewelry and to complete store enhancement projects. We invested $0.1 million in capital expenditures to open one store in Kiosk Jewelry. We also invested $1.0 million in infrastructure, primarily related to our information technology. We anticipate investing approximately $26 million in capital expenditures for the remainder of fiscal year 2012, including $1 million to open five new stores, $18 million in existing store refurbishments and approximately $7 million in capital investments related to information technology infrastructure and support operations.

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 do not expect 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

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December 15, 2011. We 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.