Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended October 31, 2012

 

Commission File Number 1-04129

 

Zale Corporation

 

A Delaware Corporation

IRS Employer Identification No. 75-0675400

 

901 W. Walnut Hill Lane

Irving, Texas 75038-1003

(972) 580-4000

 

Zale Corporation (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.

 

Zale Corporation has submitted electronically and posted on the Company’s website all Interactive Data Files required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Company was required to submit and post such files).

 

Zale Corporation is an accelerated filer.

 

Zale Corporation is not a shell company.

 

As of December 4, 2012, 32,361,396 shares of Zale Corporation’s Common Stock, par value $0.01 per share, were outstanding.

 

 

 



Table of Contents

 

ZALE CORPORATION AND SUBSIDIARIES

 

TABLE OF CONTENTS

 

 

 

 

 

Page

 

 

 

 

 

PART I. FINANCIAL INFORMATION

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

 

Consolidated Statements of Operations – Three Months Ended October 31, 2012 and 2011 (unaudited)

 

1

 

 

 

 

 

 

 

Consolidated Statements of Comprehensive Loss – Three Months Ended October 31, 2012 and 2011 (unaudited)

 

2

 

 

 

 

 

 

 

Consolidated Balance Sheets – October 31, 2012, July 31, 2012 and October 31, 2011 (unaudited)

 

3

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows – Three Months Ended October 31, 2012 and 2011 (unaudited)

 

4

 

 

 

 

 

 

 

Notes to Consolidated Financial Statements (unaudited)

 

5

 

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

13

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

19

 

 

 

 

Item 4.

Controls and Procedures

 

20

 

 

 

 

PART II. OTHER INFORMATION

 

 

 

 

 

Item 1.

Legal Proceedings

 

21

 

 

 

 

Item 1A.

Risk Factors

 

21

 

 

 

 

Item 6.

Exhibits

 

25

 



Table of Contents

 

PART I – FINANCIAL INFORMATION

 

ITEM 1.                        FINANCIAL STATEMENTS

 

ZALE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

 

 

 

Three Months Ended

 

 

 

October 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Revenues

 

$

357,468

 

$

350,983

 

Cost of sales

 

167,133

 

163,309

 

Gross margin

 

190,335

 

187,674

 

 

 

 

 

 

 

Selling, general and administrative

 

206,239

 

199,775

 

Depreciation and amortization

 

8,872

 

9,888

 

Other (gains) charges

 

(1,773

)

498

 

Operating loss

 

(23,003

)

(22,487

)

Interest expense

 

5,842

 

9,930

 

Loss before income taxes

 

(28,845

)

(32,417

)

Income tax benefit

 

(580

)

(697

)

Loss from continuing operations

 

(28,265

)

(31,720

)

Loss from discontinued operations, net of taxes

 

 

(154

)

Net loss

 

$

(28,265

)

$

(31,874

)

 

 

 

 

 

 

Basic and diluted net loss per common share:

 

 

 

 

 

Loss from continuing operations

 

$

(0.88

)

$

(0.99

)

Loss from discontinued operations

 

 

 

Net loss per share

 

$

(0.88

)

$

(0.99

)

 

 

 

 

 

 

Weighted-average number of common shares outstanding:

 

 

 

 

 

Basic

 

32,298

 

32,162

 

Diluted

 

32,298

 

32,162

 

 

See notes to consolidated financial statements.

 

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ZALE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(In thousands)

(Unaudited)

 

 

 

Three Months Ended

 

 

 

October 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Net loss

 

$

(28,265

)

$

(31,874

)

Foreign currency translation adjustment

 

514

 

(8,269

)

Unrealized (loss) gain on securities, net

 

(55

)

154

 

Comprehensive loss

 

$

(27,806

)

$

(39,989

)

 

See notes to consolidated financial statements.

 

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ZALE CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

 

 

October 31,
2012

 

July 31,
2012

 

October 31,
2011

 

 

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

14,572

 

$

24,603

 

$

30,126

 

Merchandise inventories

 

908,415

 

741,788

 

856,891

 

Other current assets

 

49,897

 

42,987

 

52,738

 

Total current assets

 

972,884

 

809,378

 

939,755

 

 

 

 

 

 

 

 

 

Property and equipment

 

698,367

 

696,485

 

701,297

 

Less accumulated depreciation and amortization

 

(577,634

)

(574,361

)

(567,045

)

Net property and equipment

 

120,733

 

122,124

 

134,252

 

 

 

 

 

 

 

 

 

Goodwill

 

100,731

 

100,544

 

100,992

 

Other assets

 

47,843

 

47,790

 

47,396

 

Deferred tax asset

 

91,189

 

91,202

 

93,388

 

Total assets

 

$

1,333,380

 

$

1,171,038

 

$

1,315,783

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ INVESTMENT

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable and accrued liabilities

 

$

332,786

 

$

205,529

 

$

300,437

 

Deferred revenue

 

83,339

 

85,714

 

82,540

 

Deferred tax liability

 

92,528

 

92,512

 

92,956

 

Total current liabilities

 

508,653

 

383,755

 

475,933

 

 

 

 

 

 

 

 

 

Long-term debt

 

524,167

 

452,908

 

493,954

 

Deferred revenue – long-term

 

115,900

 

122,802

 

137,541

 

Other liabilities

 

32,696

 

32,637

 

34,840

 

 

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ investment:

 

 

 

 

 

 

 

Common stock

 

488

 

488

 

488

 

Additional paid-in capital

 

160,012

 

162,711

 

162,139

 

Accumulated other comprehensive income

 

54,562

 

54,103

 

55,270

 

Accumulated earnings

 

396,129

 

424,394

 

419,830

 

 

 

611,191

 

641,696

 

637,727

 

Treasury stock

 

(459,227

)

(462,760

)

(464,212

)

Total stockholders’ investment

 

151,964

 

178,936

 

173,515

 

Total liabilities and stockholders’ investment

 

$

1,333,380

 

$

1,171,038

 

$

1,315,783

 

 

See notes to consolidated financial statements.

 

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ZALE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

 

 

Three Months Ended

 

 

 

October 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Cash Flows From Operating Activities:

 

 

 

 

 

Net loss

 

$

(28,265

)

$

(31,874

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Non-cash interest

 

726

 

921

 

Depreciation and amortization

 

8,872

 

9,888

 

Deferred taxes

 

25

 

(188

)

Loss on disposition of property and equipment

 

277

 

384

 

Stock-based compensation

 

1,060

 

677

 

Loss from discontinued operations

 

 

154

 

Changes in operating assets and liabilities:

 

 

 

 

 

Merchandise inventories

 

(166,704

)

(141,836

)

Other current assets

 

(7,208

)

(3,116

)

Other assets

 

532

 

(134

)

Accounts payable and accrued liabilities

 

127,611

 

82,792

 

Deferred revenue

 

(9,375

)

(10,402

)

Other liabilities

 

49

 

(2,485

)

Net cash used in operating activities

 

(72,400

)

(95,219

)

 

 

 

 

 

 

Cash Flows From Investing Activities:

 

 

 

 

 

Payments for property and equipment

 

(7,102

)

(4,299

)

Purchase of available-for-sale investments

 

(1,674

)

(3,279

)

Proceeds from sales of available-for-sale investments

 

311

 

98

 

Net cash used in investing activities

 

(8,465

)

(7,480

)

 

 

 

 

 

 

Cash Flows From Financing Activities:

 

 

 

 

 

Borrowings under revolving credit agreement

 

1,437,700

 

1,040,900

 

Payments on revolving credit agreement

 

(1,366,800

)

(942,400

)

Proceeds from exercise of stock options

 

35

 

 

Payments on capital lease obligations

 

(237

)

 

Net cash provided by financing activities

 

70,698

 

98,500

 

 

 

 

 

 

 

Cash Flows Used in Discontinued Operations:

 

 

 

 

 

Net cash used in operating activities of discontinued operations

 

 

(383

)

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

136

 

(417

)

 

 

 

 

 

 

Net change in cash and cash equivalents

 

(10,031

)

(4,999

)

Cash and cash equivalents at beginning of period

 

24,603

 

35,125

 

Cash and cash equivalents at end of period

 

$

14,572

 

$

30,126

 

 

See notes to consolidated financial statements.

 

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ZALE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.              BASIS OF PRESENTATION

 

References to the “Company,” “we,” “us,” and “our” in this Form 10-Q are references to Zale Corporation and its subsidiaries.  We are, through our wholly owned subsidiaries, a leading specialty retailer of fine jewelry in North America.  At October 31, 2012, we operated 1,117 specialty retail jewelry stores and 652 kiosks located mainly in shopping malls throughout the United States, Canada and Puerto Rico.

 

We report our operations under three segments: Fine Jewelry, Kiosk Jewelry and All Other.  Fine Jewelry is comprised of five brands, predominantly focused on the value-oriented consumer as our core guest target.  Each brand specializes in fine jewelry and watches, with merchandise and marketing emphasis focused on diamond products.  Zales Jewelers® is our national brand in the U.S. providing moderately priced jewelry to a broad range of guests.  Zales Outlet® operates in outlet malls and neighborhood power centers and capitalizes on Zale Jewelers’® national advertising and brand recognition.  Gordon’s Jewelers® is a value-oriented regional jeweler.  Peoples Jewellers®, Canada’s largest fine jewelry retailer, provides guests with an affordable assortment and an accessible shopping experience.  Mappins Jewellers® offers Canadian guests a broad selection of merchandise from engagement rings to fashionable and contemporary fine jewelry.

 

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.

 

We also maintain a presence in the retail market through our ecommerce sites www.zales.com, www.zalesoutlet.com, www.gordonsjewelers.com, www.peoplesjewellers.com and www.pagoda.com.

 

We consolidate substantially all of our U.S. operations into Zale Delaware, Inc. (“ZDel”), a wholly owned subsidiary of Zale Corporation.  ZDel is the parent company for several subsidiaries, including three that are engaged primarily in providing credit insurance to our credit customers.  We consolidate our Canadian retail operations into Zale International, Inc., which is a wholly owned subsidiary of Zale Corporation.  All significant intercompany transactions have been eliminated.  The consolidated financial statements are unaudited and have been prepared by the Company in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In management’s opinion, all material adjustments (consisting of normal recurring accruals and adjustments) and disclosures necessary for a fair presentation have been made.  Because of the seasonal nature of the retail business, operating results for interim periods are not necessarily indicative of the results that may be expected for the full year.  The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2012 filed with Securities and Exchange Commission on October 3, 2012.

 

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2.              FAIR VALUE MEASUREMENTS

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date.  In determining fair value, Accounting Standards Codification (“ASC”) 820, Fair Value Measurement, establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair values.  These tiers include:

 

Level 1 –

Quoted prices for identical instruments in active markets;

Level 2 –

Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose significant inputs are observable; and

Level 3 –

Instruments whose significant inputs are unobservable.

 

Assets that are Measured at Fair Value on a Recurring Basis

 

The following tables include our assets that are measured at fair value on a recurring basis (in thousands):

 

 

 

Fair Value as of October 31, 2012

 

 

 

Level 1

 

Level 2

 

Level 3

 

Assets

 

 

 

 

 

 

 

U.S. Treasury securities

 

$

22,623

 

$

 

$

 

U.S. government agency securities

 

 

2,875

 

 

Corporate bonds and notes

 

 

1,018

 

 

Corporate equity securities

 

4,133

 

 

 

 

 

$

26,756

 

$

3,893

 

$

 

 

 

 

Fair Value as of October 31, 2011

 

 

 

Level 1

 

Level 2

 

Level 3

 

Assets

 

 

 

 

 

 

 

U.S. Treasury securities

 

$

24,335

 

$

 

$

 

U.S. government agency securities

 

 

3,830

 

 

Corporate bonds and notes

 

 

1,838

 

 

Corporate equity securities

 

3,756

 

 

 

 

 

$

28,091

 

$

5,668

 

$

 

 

Investments in U.S. Treasury securities and corporate equity securities are based on quoted market prices for identical instruments in active markets, and therefore were classified as a Level 1 measurement in the fair value hierarchy.  Investments in U.S. government agency securities and corporate bonds and notes are based on quoted prices for similar instruments in active markets, and therefore were classified as a Level 2 measurement in the fair value hierarchy (see Note 3 for additional information related to our investments).

 

Assets that are Measured at Fair Value on a Nonrecurring Basis

 

Assets that are measured at fair value on a nonrecurring basis primarily relate to our goodwill and store-level property and equipment.  Potential impairment losses related to these assets are calculated using significant unobservable inputs including the present value of estimated future cash flows using a weighted-average cost of capital, terminal values and updated financial projections, and therefore are classified as a Level 3 measurement in the fair value hierarchy.  There were no impairments related to our goodwill and property and equipment for the three months ended October 31, 2012 and 2011.

 

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Other Financial Instruments

 

As cash and short-term cash investments, trade payables and certain other short-term financial instruments are all short-term in nature, their carrying amount approximates fair value.  The outstanding principal of our revolving credit agreement and senior secured term loan approximates fair value as of October 31, 2012.  The fair values of the revolving credit agreement and the senior secured term loan were based on estimates of current interest rates for similar debt, a Level 3 input.

 

3.              INVESTMENTS

 

Investments in debt and equity securities held by our insurance subsidiaries are reported as other assets in the accompanying consolidated balance sheets.  Investments are recorded at fair value based on quoted market prices for identical or similar securities.  All investments are classified as available-for-sale.  All long-term debt securities outstanding at October 31, 2012 will contractually mature within 1 to 20 years.  Our investments consist of the following (in thousands):

 

 

 

October 31, 2012

 

October 31, 2011

 

 

 

Cost

 

Fair Value

 

Cost

 

Fair Value

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury securities

 

$

21,092

 

$

22,623

 

$

22,704

 

$

24,335

 

U.S. government agency securities

 

2,657

 

2,875

 

3,528

 

3,830

 

Corporate bonds and notes

 

906

 

1,018

 

1,710

 

1,838

 

Corporate equity securities

 

3,501

 

4,133

 

3,501

 

3,756

 

 

 

$

28,156

 

$

30,649

 

$

31,443

 

$

33,759

 

 

At October 31, 2012 and 2011, the carrying value of investments included a net unrealized gain of $2.5 million and $2.3 million, respectively, which is included in accumulated other comprehensive income.  Realized gains and losses on investments are determined on the specific identification basis.  There were no material net realized gains or losses during the three months ended October 31, 2012 and 2011.

 

4.              LONG–TERM DEBT

 

Long-term debt consists of the following (in thousands):

 

 

 

October 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Revolving credit agreement

 

$

440,700

 

$

353,500

 

Senior secured term loan

 

80,000

 

140,454

 

Capital lease obligations

 

3,467

 

 

 

 

$

524,167

 

$

493,954

 

 

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.  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 81 to 83 percent for the period of November through December 2012, 67 to 72 percent for the period of January through September 2013 and 81 percent for October 2013.

 

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

 

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 $213 million as of October 31, 2012, which exceeded the excess availability requirement by $148 million.  The fixed charge coverage ratio was 1.57 as of October 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 October 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 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.

 

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 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 October 31, 2012, the outstanding principal under the Amended Term Loan did not exceed the borrowing base.  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 of 11 percent payable on a quarterly basis.  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 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.  As of October 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.

 

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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.  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.  Assets under capital leases included in property and equipment as of October 31, 2012 totaled $3.4 million (net of accumulated depreciation).

 

5.              OTHER (GAINS) CHARGES

 

Other (gains) charges consist of the following (in thousands):

 

 

 

Three Months Ended

 

 

 

October 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

De Beers settlement

 

$

(1,860

)

$

 

Store closure charges

 

87

 

498

 

 

 

$

(1,773

)

$

498

 

 

Beginning in June 2004, various class-action lawsuits were filed alleging that the De Beers group violated U.S. state and federal antitrust, consumer protection and unjust enrichment laws.  During the first quarter of fiscal year 2013, we received proceeds totaling $1.9 million as a result of a settlement reached in the lawsuit.

 

We have recorded lease termination charges related to certain store closures, primarily in Fine Jewelry.  The lease termination charges for leases where the Company has finalized settlement negotiations with the landlords are based on the amounts agreed upon in the termination agreement.  If a settlement has not been reached for a lease, the charges are 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.  During the three months ended October 31, 2012 and 2011, we recorded losses totaling $0.1 million and $0.5 million, respectively, as a result of adjustments to our lease reserves related to store closures.  As of October 31, 2012, the remaining lease reserve associated with the store closures totaled $0.8 million.

 

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6.              LOSS PER COMMON SHARE

 

Basic loss per common share is computed by dividing net loss by the weighted-average number of common shares outstanding for the reporting period.  Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.  For the calculation of diluted earnings per share, the basic weighted-average number of shares is increased by the dilutive effect of stock options, restricted share awards and warrants issued in connection with the senior secured term loan determined using the Treasury Stock method.  There were antidilutive stock options and restricted share awards totaling 5.0 million and 3.8 million for the three months ended October 31, 2012 and 2011, respectively.  There were antidilutive warrants totaling 11.1 million for both the three months ended October 31, 2012 and 2011.

 

During the three months ended October 31, 2012 and 2011, we incurred a net loss of $28.3 million and $31.9 million, respectively.  A net loss causes all outstanding stock options, restricted share awards and warrants to be antidilutive.  As a result, the basic and dilutive losses per common share are the same for each of the three month periods presented.

 

7.             ACCUMULATED COMPREHENSIVE INCOME

 

The following table gives further detail regarding changes in the composition of accumulated other comprehensive income (in thousands):

 

 

 

Three Months Ended

 

 

 

October 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Beginning of period

 

$

54,103

 

$

63,385

 

Foreign currency translation adjustment

 

514

 

(8,269

)

Unrealized (loss) gain on securities, net

 

(55

)

154

 

End of period

 

$

54,562

 

$

55,270

 

 

8.              INCOME TAXES

 

We are required to assess the available positive and negative evidence to estimate if sufficient future income will be generated to utilize deferred tax assets.  A significant piece of negative evidence that we consider is cumulative losses (generally defined as losses before income taxes) incurred over the most recent three-year period.  Such evidence limits our ability to consider other subjective evidence such as our projections for future growth.  As of October 31, 2012 and 2011, cumulative losses were incurred over the applicable three-year period.

 

Our valuation allowances totaled $111.0 million and $97.6 million as of October 31, 2012 and 2011, respectively.  The valuation allowances were established due to the uncertainty of our ability to utilize certain federal, state and foreign net operating loss carryforwards in the future.  The amount of the deferred tax asset considered realizable could be adjusted if negative evidence, such as three-year cumulative losses, no longer exists and additional consideration is given to our growth projections.

 

9.              SEGMENTS

 

We report our operations under three business segments: Fine Jewelry, Kiosk Jewelry, and All Other (See Note 1).  All corresponding items of segment information in prior periods have been presented consistently.  Management’s expectation is that overall economics of each of our major brands within each reportable segment will be similar over time.

 

We use earnings before unallocated corporate overhead, interest and taxes but include an internal charge for inventory carrying cost to evaluate segment profitability.  Unallocated costs before income taxes include corporate employee-related costs, administrative costs, information technology costs, corporate facilities costs and depreciation and amortization.  Income tax information by segment is not included as taxes are calculated at a company-wide level and not allocated to each segment.

 

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Three Months Ended

 

 

 

October 31,

 

Selected Financial Data by Segment

 

 

2012

 

2011

 

 

 

(amounts in thousands)

 

Revenues:

 

 

 

 

 

Fine Jewelry (a) 

 

$

306,960

 

$

301,790

 

Kiosk

 

47,818

 

46,715

 

All Other

 

2,690

 

2,478

 

Total revenues

 

$

357,468

 

$

350,983

 

 

 

 

 

 

 

Depreciation and amortization:

 

 

 

 

 

Fine Jewelry

 

$

5,799

 

$

6,181

 

Kiosk

 

744

 

774

 

All Other

 

 

 

Unallocated

 

2,329

 

2,933

 

Total depreciation and amortization

 

$

8,872

 

$

9,888

 

 

 

 

 

 

 

Operating loss:

 

 

 

 

 

Fine Jewelry

 

$

(16,702

)

$

(14,003

)

Kiosk

 

(1,749

)

(2,187

)

All Other

 

812

 

873

 

Unallocated (b) 

 

(5,364

)

(7,170

)

Total operating loss

 

$

(23,003

)

$

(22,487

)

 


(a)

Includes $63.0 million and $61.0 million for the three months ended October 31, 2012 and 2011, respectively, related to foreign operations.

 

 

(b)

Includes a gain totaling $1.9 million related to the De Beers settlement received during the three months ended October 31, 2012. Also includes credits of $15.1 million and $14.2 million for the three months ended October 31, 2012 and 2011, respectively, to offset internal carrying costs charged to the segments.

 

10.       CONTINGENCIES

 

In November 2009, the Company and four former officers, Neal L. Goldberg, Rodney Carter, Mary E. Burton and Cynthia T. Gordon, were named as defendants in two purported class-action lawsuits filed in the United States District Court for the Northern District of Texas.  On August 9, 2010, the two lawsuits were consolidated into one lawsuit, which alleged various violations of securities laws arising from the financial statement errors that led to the restatement completed by the Company as part of its Annual Report on Form 10-K for the fiscal year ended July 31, 2009.  The lawsuit requested unspecified damages and costs.  On August 1, 2011, the Court dismissed the lawsuit with prejudice.  The plaintiffs appealed the decision and on November 30, 2012 the United States Court of Appeals upheld the trial court’s decision and affirmed dismissal of the plaintiff’s case.  Plaintiffs have a limited time to petition for a rehearing or request review by the United States Supreme Court.

 

On April 21, 2011, the Securities and Exchange Commission concluded its investigation of the Company with respect to the matters underlying the lawsuit described above and did not recommend any enforcement action against the Company.  No penalties or fines were assessed to the Company.

 

We are involved in legal and governmental proceedings as part of the normal course of our business.  Reserves have been established based on management’s best estimates of our potential liability in these matters.  These estimates have been developed in consultation with internal and external counsel and are based on a combination of litigation and settlement strategies.  Management believes that such litigation and claims will be resolved without material effect on our financial position or results of operations.

 

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11.       DEFERRED REVENUE

 

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 being 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 six-year period that we have been selling the lifetime warranties.

 

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

 

The change in deferred revenue associated with the sale of warranties is as follows (in thousands):

 

 

 

Three Months Ended

 

 

 

October 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Deferred revenue, beginning of period

 

$

208,516

 

$

232,180

 

Warranties sold (a)

 

24,980

 

21,126

 

Revenue recognized

 

(34,257

)

(33,225

)

Deferred revenue, end of period

 

$

199,239

 

$

220,081

 

 


(a)

Warranty sales for the three months ended October 31, 2012 include approximately $0.1 million related to the appreciation in the Canadian currency rate on the beginning of the period deferred revenue balance. Warranty sales for the three months ended October 31, 2011 include approximately $1.7 million related to the depreciation in the Canadian currency rate on the beginning of the period deferred revenue balance.

 

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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, 2012.

 

Overview

 

We are a leading specialty retailer of fine jewelry in North America.  At October 31, 2012, we operated 1,117 fine jewelry stores and 652 kiosk locations 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 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 guest.  Kiosk Jewelry specializes in gold, silver and non-precious metal products that capitalize on the latest fashion trends.  All Other includes our insurance and reinsurance operations, which offer insurance coverage primarily to our private label credit card guests.

 

Comparable store sales increased by 3.9 percent during the first quarter of fiscal year 2013.  At constant exchange rates, which excludes the effect of translating Canadian currency denominated sales into U.S. dollars, comparable store sales increased by 3.7 percent for the quarter.  Gross margin decreased by 30 basis points to 53.2 percent during the first quarter of fiscal year 2013 due primarily to a change in sales mix to lower margin merchandise.  Net loss for the quarter was $28.3 million, compared to $31.9 million for the same period in the prior year.  The $3.6 million improvement is the result of higher sales and a decrease in interest expense, partially offset by an increase in selling, general and administrative expenses due primarily to higher labor costs.

 

Net earnings associated with warranties totaled $28.1 million for the three months ended October 31, 2012 compared to $27.9 million for the same period in the prior year.  The increase is primarily the result of improved sales.

 

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 (partially offset by closed stores), 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 included $5 million of costs associated with the debt refinancing 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 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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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 loss or other GAAP measures as an indicator of operating performance.  In addition, EBITDA should not be considered as an alternative to operating earnings (loss) or net earnings (loss) as a measure of operating performance.  Our calculation of EBITDA may differ from others in our industry and is not necessarily comparable with similar titles used by other companies.

 

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

 

 

 

Three Months Ended

 

 

 

October 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(28,265

)

$

(31,720

)

Depreciation and amortization

 

8,872

 

9,888

 

Interest expense

 

5,842

 

9,930

 

Income tax benefit

 

(580

)

(697

)

EBITDA

 

$

(14,131

)

$

(12,599

)

 

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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 Ended

 

 

 

October 31,

 

 

 

2012

 

2011

 

Revenues

 

100.0

%

100.0

%

Cost of sales

 

46.8

 

46.5

 

Gross margin

 

53.2

 

53.5

 

Selling, general and administrative

 

57.7

 

56.9

 

Depreciation and amortization

 

2.5

 

2.8

 

Other (gains) charges

 

(0.5

)

0.1

 

Operating loss

 

(6.4

)

(6.4

)

Interest expense

 

1.6

 

2.8

 

Loss before income taxes

 

(8.1

)

(9.2

)

Income tax benefit

 

(0.2

)

(0.2

)

Loss from continuing operations

 

(7.9

)

(9.0

)

Loss from discontinued operations, net of taxes

 

 

(0.1

)

Net loss

 

(7.9

)%

(9.1

)%

 

Three Months Ended October 31, 2012 Compared to Three Months Ended October 31, 2011

 

Revenues.  Revenues for the quarter ended October 31, 2012 were $357.5 million, an increase of 1.8 percent compared to revenues of $351.0 million for the same period in the prior year.  Comparable store sales increased 3.9 percent as compared to the same period in the prior year.  The increase in comparable store sales was attributable to a 3.8 percent increase in the average price per unit and a 2.6 percent increase in the number of units sold in our bridal product lines, partially offset by a decrease in the number of units sold in our core fashion product lines.  The increase in revenue was also due to a $0.8 million increase in revenues related to warranties.  The increase was partially offset by a decrease in revenues related to 52 store closures (net of store openings) since October 31, 2011.  In addition, we estimate that superstorm Sandy negatively impacted revenues during the quarter by approximately $1 million.

 

Fine Jewelry contributed $307.0 million of revenues in the quarter ended October 31, 2012, an increase of 1.7 percent compared to $301.8 million for the same period in the prior year.

 

Kiosk Jewelry contributed $47.8 million of revenues in the quarter ended October 31, 2012, an increase of 2.4 percent compared to $46.7 million in the same period in the prior year.  The increase in revenues is due to a 4.9 percent increase in the average price per unit, partially offset by a 2.7 percent decrease in the number of units sold.

 

All Other contributed $2.7 million in revenues in the quarter ended October 31, 2012, an increase of 8.6 percent compared to $2.5 million for the same period in prior year.

 

During the quarter ended October 31, 2012, we closed seven stores in Fine Jewelry and two locations in Kiosk Jewelry.

 

Gross Margin.  Gross margin represents net sales less cost of sales.  Cost of sales includes cost related to merchandise sold, receiving and distribution, guest repairs and repairs associated with warranties.  Gross margin was 53.2 percent of revenues for the quarter ended October 31, 2012, compared to 53.5 percent for the same period in the prior year.  The 30 basis point decrease was due primarily to a change in sales mix to lower margin 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 57.7 percent of revenues for the quarter ended October 31, 2012 compared to 56.9 percent for the same period in the prior year.  SG&A increased by $6.5 million to $206.2 million for the quarter ended October 31, 2012.  The increase is related to

 

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a $3.4 million increase in labor costs due primarily to our special events program that began in the second quarter of the prior year and additional training for store personnel, a $1.7 million increase in proprietary credit fees and a $1.2 million increase in healthcare costs.

 

Depreciation and Amortization.  Depreciation and amortization as a percentage of revenues for the quarter ended October 31, 2012 and 2011 was 2.5 percent and 2.8 percent, respectively.  The decrease is primarily the result of 52 store closures (net of store openings) and an increase in the number of fully depreciated assets compared to the same period in the prior year, partially offset by additional capital expenditures.

 

Other (Gains) Charges.  Other gains for the quarter ended October 31, 2012 includes proceeds totaling $1.9 million related to the De Beers settlement, partially offset by a $0.1 million charge associated with store closures.  Other charges for the quarter ended October 31, 2011 includes a $0.5 million charge associated with store closures.

 

Interest Expense.  Interest expense as a percentage of revenues for the quarters ended October 31, 2012 and 2011 was 1.6 percent and 2.8 percent, respectively.  Interest expense decreased by $4.1 million to $5.8 million for the three months ended October 31, 2012.  The decrease is due primarily to the debt refinancing transactions completed in July 2012 which resulted in an effective interest rate of 3.7 percent for the three months ended October 31, 2012, compared to 7.5 percent for the same period in the prior year.  The decrease was partially offset by an increase in the average borrowings compared to the same period in the prior year.

 

Income Tax Benefit.  Income tax benefit totaled $0.6 million for the three months ended October 31, 2012, as compared to a $0.7 million income tax benefit for the same period in the prior year.  The income tax benefit for both periods were primarily associated with operating losses related to our Canadian subsidiaries during the respective quarters.

 

Liquidity and Capital Resources

 

Our cash requirements consist primarily of funding ongoing operations, including inventory requirements, capital expenditures for new stores, renovation of existing stores, upgrades to our information technology systems and distribution facilities, and debt service.  Our cash requirements are funded through cash flows from operations and our revolving credit agreement with a syndicate of lenders led by Bank of America, N.A.  We manage availability under the revolving credit agreement by monitoring the timing of merchandise purchases and vendor payments. At October 31, 2012, we had borrowing availability under the revolving credit agreement of approximately $213 million.  The average vendor payment terms during the three months ended October 31, 2012 and 2011 were approximately 53 days and 48 days, respectively.  As of October 31, 2012, we had cash and cash equivalents totaling $14.6 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 $95.2 million for the three months ended October 31, 2011 to $72.4 million for the three months ended October 31, 2012.  The $22.8 million improvement is primarily the result of the timing of vendor payments and a $4.2 million reduction in cash paid for interest as a result of the debt refinancing transactions completed in July 2012, partially offset by an increase in inventory.

 

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 October 31, 2012 was $908.4 million, an increase of $51.5 million compared to October 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.  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

 

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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 81 to 83 percent for the period of November through December 2012, 67 to 72 percent for the period of January through September 2013 and 81 percent for October 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.

 

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 $213 million as of October 31, 2012, which exceeded the excess availability requirement by $148 million.  The fixed charge coverage ratio was 1.57 as of October 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 October 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 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.

 

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 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 October 31, 2012, the outstanding principal under the Amended Term Loan did not exceed the borrowing base.  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 of 11 percent payable on a quarterly basis.  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 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.  As of October 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.

 

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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.  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.

 

Customer Credit Programs

 

We have a Merchant Services Agreement (“MSA”) with Citibank (South Dakota), N.A. (“Citibank”), under which Citibank provides financing for our U.S. guests to purchase merchandise through private label credit cards.  The MSA expires in fiscal year 2016 and 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 October 31, 2012, we were in compliance with all covenants under the MSA.  We currently expect to exceed the $315 million threshold for the program year ending September 30, 2013.  During both the three months ended October 31, 2012 and 2011, our guests used our private label credit card to pay for approximately 33 percent and 35 percent, respectively, of purchases in the U.S.

 

We have a Private Label Credit Card Program Agreement (the “TD Agreement”) with TD Financing Services Inc. (“TDFS”), under which TDFS provides financing for our Canadian guests to purchase merchandise through private label credit cards.  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 is paid to us.  The TD Agreement expires in fiscal year 2015 and 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.  We currently expect to exceed the $50 million threshold for the program year ending June 30, 2013.  During three months ended October 31, 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.

 

We also enter into agreements with certain other lenders to offer alternative financing options to our U.S. guests who have been declined by Citibank.  During the first quarter of fiscal year 2013, we expanded our alternative credit program by entering into an agreement with Genesis Financial Solutions, Inc. to provide additional financing options to our U.S. guests.

 

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Capital Expenditures

 

During the three months ended October 31, 2012, we invested $6.1 million to remodel, relocate and refurbish stores in Fine Jewelry and to complete store enhancement projects.  We also invested $1.0 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.

 

ITEM 3.                        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Inflation.  Substantially all U.S. inventories represent finished goods, which are valued using the last-in, first-out (“LIFO”) retail inventory method.  We are required to determine the LIFO cost on an interim basis by estimating annual inflation trends, annual purchases and ending inventory.  The inflation rates pertaining to merchandise inventories, especially as they relate to diamond, gold and silver costs, are primary components in determining our LIFO inventory.  We did not record a LIFO charge during the three months ended October 31, 2012.  As a result of commodity cost increases in the prior year, we recorded LIFO charges in cost of sales totaling $0.8 million during the three months ended October 31, 2011.  The LIFO inventory reserve included in the consolidated balance sheets as of October 31, 2012 and 2011 totaled $58.3 million and $36.7 million, respectively.

 

Foreign Currency Risk.  We are not subject to significant gains or losses as a result of currency fluctuations because most of our purchases are U.S. dollar-denominated.  However, we enter into foreign currency contracts to manage the currency fluctuations associated with purchases for our Canadian operations.  The gains or losses related to the settlement of foreign currency contracts are included in SG&A in our consolidated statements of operations.  There were no material gains or losses recognized during the periods presented and there were no outstanding foreign currency contracts as of October 31, 2012.

 

We are exposed to foreign currency exchange risks through our business operations in Canada, which may adversely affect our results of operations.  During the three months ended October 31, 2012 and 2011, the average Canadian currency rate appreciated by approximately two percent and three 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, 2012 resulted in a $0.9 million increase in reported revenues, offset by an increase in reported cost of sales and selling, general and administrative expenses of $0.9 million.  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.

 

Commodity Risk.  Our results are subject to fluctuations in the underlying cost of diamonds, gold, silver and other metals which are key raw material components of the products sold by us.  We address commodity risk principally through retail price point adjustments.

 

At October 31, 2012, there were no other material changes in any of the market risk information disclosed by us in our Annual Report on Form 10-K for the fiscal year ended July 31, 2012.  More detailed information concerning market risk can be found under the sub-caption Item 7A, “Quantitative and Qualitative Disclosures about Market Risk” of the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on page 34 of our Annual Report on Form 10-K for the fiscal year ended July 31, 2012.

 

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ITEM 4.                        CONTROLS AND PROCEDURES

 

Disclosure Controls and Procedures

 

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report.  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective in enabling us to record, process, summarize and report information required to be included in the Company’s periodic SEC filings within the required time period, and that such information is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

 

Changes in Internal Control over Financial Reporting

 

There have been no changes in our internal controls over financial reporting during the quarter ended October 31, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

ITEM 1.                        LEGAL PROCEEDINGS

 

Information regarding legal proceedings is incorporated by reference from Note 10 to our consolidated financial statements set forth, under the heading, “Contingencies,” in Part I of this report.

 

ITEM 1A.               RISK FACTORS

 

We make forward-looking statements in this Quarterly Report on Form 10-Q and in other reports we file with the Securities and Exchange Commission (“SEC”).  In addition, members of our senior management make forward-looking statements orally in presentations to analysts, investors, the media and others.  Forward-looking statements include statements regarding our objectives and expectations with respect to our financial plan (including expectations for earnings, comparable store sales, gross margin, selling, general and administrative expenses, interest expense and the effective tax rate for fiscal year 2013), merchandising and marketing strategies, acquisitions and dispositions, share repurchases, store openings, renovations, remodeling and expansion, inventory management and performance, liquidity and cash flows, capital structure, capital expenditures, development of our information technology and telecommunications plans and related management information systems, ecommerce initiatives, human resource initiatives and other statements regarding our plans and objectives.  In addition, the words “plans to,” “anticipate,” “estimate,” “project,” “intend,” “expect,” “believe,” “forecast,” “can,” “could,” “should,” “will,” “may,” or similar expressions may identify forward-looking statements, but some of these statements may use other phrasing.  These forward-looking statements are intended to relay our expectations about the future, and speak only as of the date they are made.  We disclaim any obligation to update or revise publicly or otherwise any forward-looking statements to reflect subsequent events, new information or future circumstances.

 

Forward-looking statements are not guarantees of future performance and a variety of factors could cause our actual results to differ materially from the anticipated or expected results expressed in or suggested by these forward-looking statements.

 

If the general economy performs poorly, discretionary spending on goods that are, or are perceived to be, “luxuries” may not grow and may decrease.

 

Jewelry purchases are discretionary and may be affected by adverse trends in the general economy (and consumer perceptions of those trends).  In addition, a number of other factors affecting consumers such as employment, wages and salaries, business conditions, energy costs, credit availability and taxation policies, for the economy as a whole and in regional and local markets where we operate, can impact sales and earnings.  The economic downturn that began in 2008 has significantly impacted our sales and the continuation of this downturn, and particularly its worsening, would have a material adverse impact on our business and financial condition.

 

The concentration of a substantial portion of our sales in three relatively brief selling periods means that our performance is more susceptible to disruptions.

 

A substantial portion of our sales are derived from three selling periods—Holiday (Christmas), Valentine’s Day and Mother’s Day.  Because of the briefness of these three selling periods, the opportunity for sales to recover in the event of a disruption or other difficulty is limited, and the impact of disruptions and difficulties can be significant.  For instance, adverse weather (such as a blizzard or hurricane), a significant interruption in the receipt of products (whether because of vendor or other product problems), or a sharp decline in mall traffic occurring during one of these selling periods could materially impact sales for the affected period and, because of the importance of each of these selling periods, commensurately impact overall sales and earnings.

 

Any disruption in the supply of finished goods from our largest merchandise vendors could adversely impact our sales.

 

We purchase substantial amounts of finished goods from our five largest merchandise vendors.  If our supply with these top vendors was disrupted, particularly at certain critical times of the year, our sales could be adversely affected in the short-term until alternative supply arrangements could be established.

 

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Most of our sales are of products that include diamonds, precious metals and other commodities.  A substantial portion of our purchases and sales occur outside the United States.  Fluctuations in the availability and pricing of commodities or exchange rates could impact our ability to obtain, produce and sell products at favorable prices.

 

The supply and price of diamonds in the principal world market are significantly influenced by a single entity, which has traditionally controlled the marketing of a substantial majority of the world’s supply of diamonds and sells rough diamonds to worldwide diamond cutters at prices determined in its sole discretion.  The availability of diamonds also is somewhat dependent on the political conditions in diamond-producing countries and on the continuing supply of raw diamonds.  Any sustained interruption in this supply could have an adverse affect on our business.

 

We also are affected by fluctuations in the price of diamonds, gold and other commodities.  A significant change in prices of key commodities could adversely affect our business by reducing operating margins or decreasing consumer demand if retail prices are increased significantly.  During the last few years, our vendors have experienced significant increases in commodity costs, especially diamond, gold and silver costs.  If significant increases in commodity prices occur in the future, it could result in higher merchandise costs, which could materially impact our earnings.  In addition, foreign currency exchange rates and fluctuations impact costs and cash flows associated with our Canadian operations and the acquisition of inventory from international vendors.

 

A substantial portion of our raw materials and finished goods are sourced in countries generally described as having developing economies.  Any instability in these economies could result in an interruption of our supplies, increases in costs, legal challenges and other difficulties.

 

In August 2012, the SEC issued rules that require companies that manufacture products using certain minerals, including gold, to determine whether those minerals originated in the Democratic Republic of Congo (“DRC”) or adjoining countries.  If the minerals originate in the DRC, or if companies are not able to establish where they originated, extensive disclosure regarding the sources of those minerals, and in some instances an independent audit of the supply chain, is required.  The costs of complying with the new rules are not expected to be material.  The Company will be required to file its first disclosure report by May 31, 2014 for the calendar year ending December 31, 2013.

 

Our sales are dependent upon mall traffic.

 

Our stores and kiosks are located primarily in shopping malls throughout the U.S., Canada and Puerto Rico.  Our success is in part dependent upon the continued popularity of malls as a shopping destination and the ability of malls, their tenants and other mall attractions to generate customer traffic.  Accordingly, a significant decline in this popularity, especially if it is sustained, would substantially harm our sales and earnings.  In addition, even assuming this popularity continues, mall traffic can be negatively impacted by weather, gas prices and similar factors.

 

We operate in a highly competitive and fragmented industry.

 

The retail jewelry business is highly competitive and fragmented, and we compete with nationally recognized jewelry chains as well as a large number of independent regional and local jewelry retailers and other types of retailers who sell jewelry and gift items, such as department stores and mass merchandisers.  We also compete with internet sellers of jewelry.  Because of the breadth and depth of this competition, we are constantly under competitive pressure that both constrains pricing and requires extensive merchandising efforts in order for us to remain competitive.

 

Any failure by us to manage our inventory effectively, including judgments related to consumer preferences and demand, will negatively impact our financial condition, sales and earnings.

 

We purchase much of our inventory well in advance of each selling period.  In the event we do not stock merchandise consumers wish to purchase or misjudge consumer demand, we will experience lower sales than expected and will have excessive inventory that may need to be written down in value or sold at prices that are less than expected, which could have a material adverse impact on our business and financial condition.

 

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Unfavorable consumer responses to price increases or misjudgments about the level of markdowns could have a material adverse impact on our sales and earnings.

 

From time to time, and especially in periods of rising raw material costs, we increase the retail prices of our products.  Significant price increases could impact our earnings depending on, among other factors, the pricing by competitors of similar products and the response by the guest to higher prices.  Such price increases may result in lower unit sales and a subsequent decrease in gross margin and adversely impact earnings.  In addition, if we misjudge the level of markdowns required to sell our merchandise at acceptable turn rates, sales and earnings could be negatively impacted.

 

Any failure of our pricing and promotional strategies to be as effective as desired will negatively impact our sales and earnings.

 

We set the prices for our products and establish product specific and store-wide promotions in order to generate store traffic and sales.  While these decisions are intended to maximize our sales and earnings, in some instances they do not.  For instance, promotions, which can require substantial lead time, may not be as effective as desired or may prove unnecessary in certain economic circumstances.  Where we have implemented a pricing or promotional strategy that does not work as expected, our sales and earnings will be adversely impacted.

 

Because of our dependence upon a small concentrated number of landlords for a substantial number of our locations, any significant erosion of our relationships with those landlords or their financial condition would negatively impact our ability to obtain and retain store locations.

 

We are significantly dependent on our ability to operate stores in desirable locations with capital investment and lease costs that allow us to earn a reasonable return on our locations.  We depend on the leasing market and our landlords to determine supply, demand, lease cost and operating costs and conditions.  We cannot be certain as to when or whether desirable store locations will become or remain available to us at reasonable lease and operating costs.  Several large landlords dominate the ownership of prime malls, and we are dependent upon maintaining good relations with those landlords in order to obtain and retain store locations on optimal terms.  From time to time, we do have disagreements with our landlords and a significant disagreement, if not resolved, could have an adverse impact on our business.  In addition, any financial weakness on the part of our landlords could adversely impact us in a number of ways, including decreased marketing by the landlords and the loss of other tenants that generate mall traffic.

 

Any disruption in, or changes to, our private label credit card arrangements may adversely affect our ability to provide consumer credit and write credit insurance.

 

We rely on third party credit providers to provide financing for our guests to purchase merchandise and credit insurance through private label credit cards.  Any disruption in, or changes to, our credit card agreements would adversely affect our sales and earnings.

 

Significant restrictions in the amount of credit available to our guests could negatively impact our business and financial condition.

 

Our guests rely heavily on financing provided by credit lenders to purchase our merchandise.  The availability of credit to our guests is impacted by numerous factors, including general economic conditions and regulatory requirements relating to the extension of credit.  Numerous federal and state laws impose disclosure and other requirements upon the origination, servicing and enforcement of credit accounts and limitations on the maximum amount of finance charges that may be charged by a credit provider.  Regulations implementing the Credit Card Accountability Responsibility and Disclosure Act of 2009 imposed new restrictions on credit card pricing, finance charges and fees, customer billing practices and payment application.  Future regulations or changes in the application of current laws could further impact the availability of credit to our guests.  If the amount of available credit provided to our guests is significantly restricted, our sales and earnings would be negatively impacted.

 

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We are dependent upon our revolving credit agreement, senior secured term loan and other third party financing arrangements for our liquidity needs.

 

We have a revolving credit agreement and a senior secured term loan that contain various financial and other covenants.  Should we be unable to fulfill the covenants contained in these loans, we would be in default, all outstanding amounts would be immediately due, and we would be unable to fund our operations without a significant restructuring of our business.

 

If the credit markets deteriorate, our ability to obtain the financing needed to operate our business could be adversely impacted.

 

We utilize a revolving credit agreement to finance our working capital requirements, including the purchase of inventory, among other things.  If our ability to obtain the financing needed to meet these requirements was adversely impacted as a result of continued deterioration in the credit markets, our business could be significantly impacted.  In addition, the amount of available borrowings under our revolving credit agreement is based, in part, on the appraised liquidation value of our inventory.  Any declines in the appraised value of our inventory could impact our ability to obtain the financing necessary to operate our business.

 

Any security breach with respect to our information technology systems could result in legal or financial liabilities, damage to our reputation and a loss of guest confidence.

 

During the course of our business, we regularly obtain and transmit through our information technology systems customer credit and other data.  If our information technology systems are breached due to the actions of outside parties, or otherwise, an unauthorized third party may obtain access to confidential guest information.  Any breach of our systems that results in unauthorized access to guest information could cause us to incur significant legal and financial liabilities, damage to our reputation and a loss of customer confidence.  In each case, these impacts could have an adverse effect on our business and results of operations.

 

Acquisitions and dispositions involve special risk, including the risk that we may not be able to complete proposed acquisitions or dispositions or that such transactions may not be beneficial to us.

 

We have made significant acquisitions and dispositions in the past and may in the future make additional acquisitions and dispositions.  Difficulty integrating an acquisition into our existing infrastructure and operations may cause us to fail to realize expected return on investment through revenue increases, cost savings, increases in geographic or product presence and guest reach, and/or other projected benefits from the acquisition.  In addition, we may not achieve anticipated cost savings or may be unable to find attractive investment opportunities for funds received in connection with a disposition.  Additionally, attractive acquisition or disposition opportunities may not be available at the time or pursuant to terms acceptable to us and we may be unable to complete acquisitions or dispositions.

 

Litigation and claims can adversely impact us.

 

We are involved in various legal proceedings as part of the normal course of our business.  Where appropriate, we establish reserves based on management’s best estimates of our potential liability in these matters.   While management believes that all current litigation and claims will be resolved without material effect on our financial position or results of operations, as with all litigation it is possible that there will be a significant adverse outcome.

 

Ineffective internal controls can have adverse impacts on the Company.

 

Under Federal law, we are required to maintain an effective system of internal controls over financial reporting.  Should we not maintain an effective system, it would result in a violation of those laws and could impair our ability to produce accurate and timely financial statements.  In turn, this could result in increased audit costs, a loss of investor confidence, difficulties in accessing the capital markets, and regulatory and other actions against us.  Any of these outcomes could be costly to both our shareholders and us.

 

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Changes in estimates, assumptions and judgments made by management related to our evaluation of goodwill and other long-lived assets for impairment could significantly affect our financial results.

 

Evaluating goodwill and other long-lived assets for impairment is highly complex and involves many subjective estimates, assumptions and judgments by our management.  For instance, management makes estimates and assumptions with respect to future cash flow projections, terminal growth rates, discount rates and long-term business plans.  If our actual results are not consistent with our estimates, assumptions and judgments made by management, we may be required to recognize impairments.

 

Additional factors may adversely affect our financial performance.

 

Increases in expenses that are beyond our control including items such as increases in interest rates, inflation, fluctuations in foreign currency rates, higher tax rates and changes in laws and regulations, may negatively impact our operating results.

 

ITEM 6.                       EXHIBITS

 

The following exhibits are filed as part of, or incorporated by reference into, this Quarterly Report on Form 10-Q.

 

Exhibit
Number

 

Description of Exhibit

31.1*

 

Rule 13a-14(a) Certification of Principal Executive Officer

31.2*

 

Rule 13a-14(a) Certification of Chief Administrative Officer

31.3*

 

Rule 13a-14(a) Certification of Principal Financial Officer

32.1*

 

Section 1350 Certification of Principal Executive Officer

32.2*

 

Section 1350 Certification of Chief Administrative Officer

32.3*

 

Section 1350 Certification of Principal Financial Officer

101.INS**

 

XBRL Instance Document

101.SCH**

 

XBRL Taxonomy Extension Schema

101.CAL**

 

XBRL Taxonomy Extension Calculation Linkbase

101.DEF**

 

XBRL Taxonomy Extension Definition Linkbase

101.LAB**

 

XBRL Taxonomy Extension Label Linkbase

101.PRE**

 

XBRL Taxonomy Extension Presentation Linkbase

 


*                    Filed herewith.

 

**             These exhibits are furnished herewith.  In accordance with Rule 406T of Regulation S-T, these exhibits are not deemed to be filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are not deemed to be filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under these sections.

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

ZALE CORPORATION

 

(Registrant)

 

 

 

 

Date: December 7, 2012

By:

/s/ THOMAS A. HAUBENSTRICKER

 

 

Thomas A. Haubenstricker

 

 

Chief Financial Officer

 

 

(principal financial officer of the registrant)

 

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