ITEM 1. BUSINESS
General
We are, through our wholly owned subsidiaries, North America’s largest specialty retailer of fine jewelry. At July 31, 2006, we operated 1,456 specialty retail jewelry stores, 817 kiosks and 76 carts located mainly in shopping malls throughout the United States of America (“U.S.”), Canada and Puerto Rico.
We were incorporated in Delaware in 1993. Our principal executive offices are located at 901 W. Walnut Hill Lane, Irving, Texas 75038-1003. Our telephone number at that address is (972) 580-4000, and our Internet address is www.zalecorp.com.
During the fiscal year ended July 31, 2006 (“fiscal year 2006”), we generated $2.4 billion of net revenues. We believe we are well-positioned to compete in the approximately $61 billion, combined U.S. and Canadian retail jewelry industry, leveraging our established brand names, economies of scale and geographic and demographic diversity. We have significant brand name recognition as a result of each brand’s long-standing presence in the industry and our national and regional advertising campaigns. We believe that brand name recognition is an important advantage in jewelry retailing as jewelry products are generally unbranded and consumers must trust in a retailer’s reliability, credibility and commitment to customer service.
Business Segments
We report our operations under three business segments: Fine Jewelry, Kiosk Jewelry and All Other. An overview of each business segment follows below. During fiscal year 2006, our Fine Jewelry segment generated $2.1 billion or approximately 88 percent of net revenues. During fiscal year 2006, the Kiosk revenues represented $276.7 million or approximately 11 percent of our total revenues.
Fine Jewelry
Our Fine Jewelry segment is comprised of six brands, each targeted to reach a distinct customer. 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 customers. Zales Jewelers has extended the reach of its brand to the Internet shopper through its e-commerce site, zales.com. We have further leveraged the brand strength through Zales Outlet, which focuses on a slightly higher-income female self purchaser in outlet malls and neighborhood power centers. Gordon’s Jewelers® is a regional jeweler focusing on customer driven assortments. Bailey Banks & Biddle Fine Jewelers® operates jewelry stores that are considered among the finest luxury jewelry stores in their markets, offering designer jewelry and prestige watches to attract more affluent customers. Bailey Banks & Biddle Fine Jewelers has expanded its presence in the luxury market through its e-commerce site, baileybanksandbiddle.com . Peoples Jewellers Ò and Mappins Jewellers® offer moderately priced jewelry in malls throughout Canada.
Zale North America
In fiscal year 2006, we consolidated the management of our flagship brands in the U.S. and Canada, Zales Jewelers, Peoples Jewellers, and Mappins Jewellers, respectively, under one senior management team, thereby creating Zale North America.
Zales Jewelers. Zales, our national flagship, is a leading brand name in jewelry retailing in the U.S., with 784 stores in 50 states and Puerto Rico, and accounted for approximately 44 percent of our total revenues in fiscal year 2006. Zales’ average store size is 1,666 square feet with an average transaction total of $358 in fiscal year 2006.
While placing added emphasis on the bridal segment of its business, Zales maintains a balance with non-bridal merchandise such as fashion jewelry and watches as well as its Brilliant Buy and promotional
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strategy to drive sales during gift-giving occasions and throughout the year. In fiscal year 2006, bridal merchandise represented 45 percent of Zales’ merchandise sales, while fashion jewelry and watches comprised the remaining 55 percent. The bridal merchandise category consists of engagement rings, bridal sets and diamond anniversary bands. Fashion jewelry consists of diamond fashion jewelry, precious and semi-precious jewelry, gold jewelry, watches and various other items. We believe that the prominence of diamond jewelry in our product selection and our reputation for customer service for over 80 years fosters an image of quality and trust among consumers.
As the Zales brand entered into fiscal year 2006, the brand was repositioned, including more stylish and upscale merchandise in its assortments and marketing. The strategy did not succeed and significant changes were made (see “Business Developments” on page 4) with a goal of regaining market share.
Zales, a multi-channel retailer, serves the Internet customer through its e-commerce site, zales.com , which accounted for approximately one percent of our total revenues in fiscal year 2006.
Peoples Jewellers and Mappins Jewellers. In Canada, we operate 175 stores in nine provinces and enjoy the largest market share of any specialty jewelry retailer in Canada. Canadian operations consists of two brands, Peoples Jewellers and Mappins Jewellers. Canadian operations accounted for approximately nine percent of our total revenues in fiscal year 2006. The average store size is 1,590 square feet with an average transaction totaling $283 in fiscal year 2006.
Peoples Jewellers and Mappins Jewellers are two of the most recognized brand names in Canada. Peoples Jewellers offers jewelry at affordable prices, attracting a wide variety of Canadian customers. Using the trademark “Peoples, the Diamond Store” in Canada, Peoples emphasizes its diamond business while also offering a wide selection of gold jewelry, gemstone jewelry and watches. Due to the similarity in marketing and store designs, Peoples Jewellers is able to leverage opportunities with Zales Jewelers. Since 2000, the Peoples brand has been building recognition with an aggressive television campaign. Over the past three years, Peoples had the largest television campaign of any Canadian jewelry retailer by a wide margin. Seasonal newspaper inserts are also a key element in the Peoples marketing campaign. Mappins Jewellers differentiates itself by offering exclusive merchandise primarily in its bridal assortments. Since 2000, Mappins has utilized newspaper inserts and targeted direct mail offers to reach its customers.
Zales Outlet
We operated Zales Outlet with stores in 35 states and Puerto Rico which accounted for approximately seven percent of our total revenues in fiscal year 2006. The average store size is 2,385 square feet, with an average transaction total of $398 in fiscal year 2006.
The outlet concept has evolved into one of the strongest concepts in retail shopping today, featuring items in every major jewelry category including branded watches, gemstones, gold merchandise, and diamond fashion and solitaire products. The merchandise assortment in a typical Zales Outlet store caters to the higher-income female self purchaser, offering 20 to 70 percent off traditional retail prices every day. We have grown our Zales Outlet concept over the past eight years from four stores in 1998 to the 131 stores in operation at the end of fiscal year 2006.
Although Zales Outlet was established as an extension of the Zales brand and capitalizes on Zales’ national advertising and brand recognition, Zales Outlet offers its own unique product line and augments this with promotional efforts that are geared specifically to the outlet consumer.
Gordon’s Jewelers
Gordon’s is positioned as our second mall-based brand. As of July 31, 2006, Gordon’s had 293 stores in 35 states and Puerto Rico and accounted for approximately 14 percent of our total revenues in fiscal year 2006. Average store size is 1,512 square feet with an average transaction total of $416 in fiscal year 2006. Gordon’s strives to distinguish itself by understanding local and regional differences to tailor its assortments more appropriately for each store’s locale.
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We are continuing steps to differentiate the Gordon’s brand and determine the proper positioning of the brand. We believe its strengths include versioned product assortments and merchandise that caters to local ethnic demographics.
Bailey Banks & Biddle Fine Jewelers
At July 31, 2006, Bailey Banks & Biddle operated 73 upscale jewelry stores in 25 states. We also utilize the trade name Zell Bros® for one location operated by the Bailey Banks & Biddle brand. Average store size is 3,994 square feet with an average transaction total of $1,610 (excluding closed stores) in fiscal year 2006. Total revenue at Bailey Banks & Biddle accounted for approximately 13 percent of our total revenues in fiscal year 2006.
During the second quarter of fiscal year 2006, we closed 32 Bailey Banks & Biddle stores as part of the brand’s strategy to improve profitability and performance. As a result of the store closings, we incurred charges of approximately $21.2 million or $0.43 per diluted share after taxes related to inventory, leasehold improvements, and lease exit costs.
For 172 years, Bailey Banks & Biddle has combined classic jewelry with contemporary designs, offering a compelling shopping environment for the high-end luxury consumer. Bailey Banks & Biddle locations are among the preeminent stores in their markets. They carry both exclusive and recognized branded and designer merchandise selections to appeal to the more affluent customer. The Bailey Banks & Biddle merchandise assortments are carefully selected to provide treasures that will be appreciated for generations with a focus on diamonds, precious gemstones, gold, and branded designer jewelry, complemented by an extensive assortment of prestige watch brands and giftware.
Kiosk Jewelry
The Kiosk Jewelry segment operates primarily under the brand names Piercing Pagoda®, Plumb Gold™, Silver and Gold Connection® (in the U.S.) and Peoples II™ (in Canada) through mall based kiosks and carts and reaches the opening price point select jewelry customer. The Kiosk Jewelry segment specializes in gold and silver products that capitalize on the latest fashion trends.
At July 31, 2006, Piercing Pagoda operated 817 locations in 42 states and Puerto Rico. During fiscal year 2006, we operated 76 carts in Canada under the name Peoples II, which sell items consistent with the best selling fashion items in the Piercing Pagoda kiosks.
At the entry-level price point, the Kiosk Jewelry segment targets a young, fashion forward customer. The kiosks and carts offer an extensive collection of popularly priced bracelets, earrings, charms, rings, and 14 karat and 10 karat gold chains, as well as a selection of silver and diamond jewelry, all in basic styles at moderate prices. In addition, trained associates perform ear-piercing services on site.
Kiosks and carts are generally located in high traffic locations that are easily accessible and visible within regional shopping malls. The kiosk locations average 189 square feet in size, with an average transaction of $38 in fiscal year 2006.
All Other
We provide insurance and reinsurance facilities for various types of insurance coverage, which typically are marketed to our private label credit card customers, through Zale Indemnity Company, Zale Life Insurance Company and Jewel Re-Insurance Ltd. The three companies are the insurers (either through direct written or reinsurance contracts) of our customer credit insurance coverages. In addition to providing merchandise replacement coverage for certain perils, credit insurance coverage provides protection to the creditor and cardholder for losses associated with the disability, involuntary unemployment, leave of absence or death of the cardholder. Zale Life Insurance Company also provides group life insurance coverage for our eligible employees. Zale Indemnity Company, in addition to writing direct credit insurance contracts, has certain discontinued lines of insurance that it continues to service. Credit insurance operations are dependent on our retail sales through our private label credit cards. In fiscal year 2006, 39.8 percent of our private label credit card purchasers purchased some form of credit insurance. Under the current private label arrangement with Citibank U.S.A., N.A. (“Citi”), our insurance affiliates continue to
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provide insurance to holders of our private label credit cards and receive payments for such insurance products. In fiscal year 2006, the All Other Segment accounted for less than 1 percent of our total revenues.
Business Developments
During fiscal year 2006 there were significant changes in our management team. Effective January 31, 2006, President and Chief Executive Officer Mary L. Forté resigned and Mary E. Burton, a member of our Board of Directors, was appointed Acting Chief Executive Officer. Subsequently, Ms. Burton was permanently appointed as President and Chief Executive Officer. She remains as a director of the Company.
Effective February 16, 2006, John Zimmermann was appointed President of Zale North America, responsible for the Zales Jewelers, Peoples Jewellers, Mappins Jewellers, and Peoples II brands. Mr. Zimmermann had formerly been President of Zale Canada which included the Peoples Jewellers and Mappins Jewellers brands.
On March 23, 2006, Chief Operating Officer and Executive Vice President Sue E. Gove resigned.
On May 5, 2006, Chief Financial Officer and Group Senior Vice President Mark Lenz was placed on administrative leave. This decision was made after discussions with our outside auditors concerning Mr. Lenz’s failure to timely disclose in conversations with the auditors that vendor payments scheduled to be made during the last two weeks of our fiscal year ended July 31, 2005 were delayed until the first week of August 2005. Cash and accounts payable were properly reflected on the balance sheet. Mr. Lenz’s employment ended on July 31, 2006 upon the expiration of his employment contract.
On May 5, 2006, George R. Mihalko, Jr. was elected as a director of the Company and agreed to serve as Acting Chief Administrative Officer and Acting Chief Financial Officer.
Rodney Carter was appointed Chief Financial Officer and Group Senior Vice President, effective October 16, 2006. Prior to joining the Company, Mr. Carter was the Senior Vice President and Chief Financial Officer of PETCO Animal Supplies, Inc., and prior to that position, was the Executive Vice President and Chief Financial Officer for CEC Entertainment, Inc.
In making these executive changes, we reiterated our commitment to long-term growth through our core strategies of regaining market share, increasing margin through direct sourcing and internal production of diamond product, and making investments in our people.
In the fourth quarter of fiscal year 2006, we recorded an after tax special charge primarily consisting of (1) $16.8 million to accelerate inventory markdowns on discontinued items, (2) $3.3 million related to the termination of an information technology initiative not consistent with the needs of our business, and (3) a $2.9 million asset impairment related to certain test stores. Separately, we recorded a $1.5 million after tax charge for accrued percentage rent related to prior periods and a $1.9 million tax charge primarily related to Canadian earnings.
Business Initiatives and Strategy
Regain Market Share
We believe rebuilding the Zales brand is key to our return to a leadership position. Last Holiday season, assortments were repositioned with less emphasis on diamond fashion to a focus on trendier styles. This repositioning was not successful. The merchandise direction for fiscal year 2007 will include a renewed emphasis on diamond fashion and solitaire engagement rings, dominant assortments across bridal and diamond fashion and consistent assortments of moderately priced merchandise across all stores. In addition to more robust assortments, Zales will reemphasize Brilliant Buys and add back key promotional events backed by television advertising.
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In the upcoming Holiday season, a new creative, a return to “Zales, the Diamond Store,” and a focus on the breadth and depth of assortments will better position the Zales brand. The strategy also includes an investment in store personnel, a revised compensation structure and increased product training, as well as additional training to translate product knowledge to sales. We believe this approach should result in higher average store revenues and is consistent with our strategy of regaining market leadership.
We believe our brand recognition is a competitive advantage across each of our nameplates. This is especially important because, when consumers feel they lack the expertise to evaluate the quality and value of jewelry purchases, they rely on known brand names to ensure quality and value. As an industry leader, we continue to set the standard for delivering innovative and creatively designed products to consumers. We believe our proven ability to capitalize on evolving merchandise trends and interpret those trends to our entire customer base is what differentiates us from our competition. In addition, as the largest specialty retailer of fine jewelry in North America, we believe we realize economies of scale in purchasing, distribution, leasing, advertising and administrative costs. We also believe that the geographic diversity of our retail distribution network through all 50 states, Puerto Rico and Canada, and the demographic breadth of our target customer groups may serve to reduce earnings volatility typically associated with local or regional conditions.
During the second quarter of fiscal year 2006, we closed 32 Bailey Banks & Biddle stores that did not fit with the brand’s long term positioning in the luxury market and as part of the brand’s strategy to improve performance and profitability. The closings resulted in a charge of approximately $21.2 million or $0.43 per diluted share after taxes related to inventory, leasehold improvements, and lease exit costs.
In fiscal year 2006, we tested a repair store concept with three locations that were ultimately closed.
In fiscal year 2007, we plan to open approximately 58 new stores, principally under the brand names Peoples Jewellers, Mappins Jewellers, Zales Jewelers, and Zales Outlet, as well as 10 Piercing Pagoda kiosks. We expect to incur an aggregate of approximately $22 million in capital expenditures. During fiscal year 2007, we also plan to refurbish, renovate or relocate approximately 170 stores and kiosks at a cost of approximately $40 million.
Improve Gross Margin
We plan to increase direct product sourcing to enhance margins, ensure consistency of quality, and reliability of supply. This initiative consists of two opportunities: (1) the purchase and assembly of cut and polished diamonds into a finished jewelry product and (2) direct importing of finished goods.
We have a direct sourcing organization to coordinate the purchase and assembly of mountings and loose diamonds into finished diamond product. This organization supplied approximately $84 million in purchases for our Canadian fine jewelry brands, Zales, Gordon’s and Outlet, making it one of our largest sources for product in fiscal year 2006.
In addition to the purchase and assembly of diamond products, direct importing of finished product from overseas vendors also was identified as an opportunity. The Kiosk Jewelry segment and the Fine Jewelry segment import basic gold and diamond merchandise directly from factories in Europe, Asia and the Middle East in order to reduce product cost.
During fiscal year 2006, direct product sourcing of our merchandise improved gross margins on the related products. In fiscal year 2006, we had gross margin improvements of 60 basis points related to direct product sourcing. In fiscal year 2007, we expect to further improve margins by increasing the percent of directly sourced product, particularly at Zales Jewelers.
As we move into fiscal year 2007, our Information Technology department has repositioned its strategic initiatives by linking our business needs with related technology investments. More efficient and effective store processes will be enabled as newer point-of-sale (“POS”) software is introduced at select pilot stores. Additionally, we expect to design and begin implementing a best-in-class merchandising, planning and allocation system. By electing a modular system, we believe certain supply chain benefits will be achieved beginning in late fiscal year 2007 with a full implementation set for completion in fiscal year 2009 (August 1, 2008 to July 31, 2009). This direction marks a departure from an enterprise-wide
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solution that we determined did not meet the needs of our business. We recorded an after tax charge of $3.3 million or $0.07 per diluted share related to the abandoned information technology initiative.
Invest in People
We are investing in people to make sure we attract and retain the best associates. We are investing in training to support our customers’ need for knowledgeable sales associates. The strategy also includes an investment in store personnel, a revised compensation structure and increased product training as well as additional training to translate product knowledge to sales.
In fiscal year 2006, we increased the number of employees who completed product training through the Diamond Council of America (“DCA”). Additionally, we have a well-developed buyer training program to develop and train new buyers on merchandise negotiation techniques and Company standards.
Current Year Capital
On August 30, 2005, we announced that our Board of Directors had approved a stock repurchase program pursuant to which we, from time to time, at management’s discretion and in accordance with our usual policies and applicable securities laws, could purchase up to an additional $100 million of our common stock. During the first six months of fiscal year 2006, we repurchased 3.7 million shares of common stock at an aggregate cost of approximately $100 million, which completed the Board’s authorization under the fiscal year 2006 program. We will reevaluate the possible repurchase of additional shares after the upcoming Holiday season.
In 2007, we are investing our capital resources in new inventory assortments, new stores and remodeling locations, and information technology initiatives to ensure the long-term growth of our brands.
Industry and Competition
Jewelry retailing is highly competitive. We compete with a large number of independent regional and local jewelry retailers, as well as with other national jewelry chains. We also compete with other types of retailers who sell jewelry and gift items such as department stores, discounters, direct mail suppliers, online retailers and television home shopping programs. Certain of our competitors are non-specialty retailers, which are larger and have greater financial resources than we do. The malls where most of our stores are located typically contain competing national chains, independent jewelry stores and/or department store jewelry departments. We believe that we are also competing for consumers’ discretionary spending dollars and, therefore, compete with retailers who offer merchandise other than jewelry or giftware. Therefore, we compete primarily on the basis of our reputation for high quality products, brand recognition, store location, distinctive and value-priced merchandise, personalized customer service and ability to offer private label credit card programs to customers wishing to finance their purchases. Our success is also dependent on our ability to both react to and create customer demand for specific merchandise categories.
The U.S. and Canadian retail jewelry industry accounted for approximately $61 billion of sales in 2005, according to publicly available data. We have a four percent market share in the combined U.S. and Canadian markets. The largest jewelry retailer in the combined U.S. and Canadian markets is believed to be Wal-Mart Stores, Inc. Other significant segments of the fine jewelry industry include national chain department stores (such as J.C. Penney Company, Inc. and Sears, Roebuck and Co.), mass merchant discount stores (such as Wal-Mart Stores, Inc.), other general merchandise stores and apparel and accessory stores. The remainder of the retail jewelry industry is comprised primarily of catalog and mail order houses, direct-selling establishments, TV shopping networks (such as QVC, Inc.) and online jewelers.
Historically, retail jewelry store sales have exhibited limited cyclicality. The United States Census Bureau has recorded only three years of negative growth in specialty retail jewelry store sales from 1984 to 2005.
We hold no material patents, licenses, franchises or concessions; however, our established trademarks and trade names are essential to maintaining our competitive position in the retail jewelry industry.
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Operations by Brand
The following table presents total revenues, average sales per location and the number of locations for each of our brands for the periods indicated.
| Year Ended July 31, 2006 | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Total Revenues (in thousands) |
||||||||||||
Zales (including ZLC Direct) |
$ | 1,092,625 | $ | 1,079,230 | $ | 1,070,576 | ||||||
Zales Outlet |
177,736 | 166,000 | 137,613 | |||||||||
Gordon’s |
339,510 | 324,854 | 313,881 | |||||||||
Bailey Banks & Biddle (a) |
309,311 | 320,869 | 326,086 | |||||||||
Peoples (b) |
229,574 | 198,308 | 174,058 | |||||||||
Piercing Pagoda |
268,936 | 274,296 | 269,660 | |||||||||
Peoples II |
7,683 | 6,601 | — | |||||||||
Insurance Revenues/Other |
13,602 | 12,908 | 12,566 | |||||||||
| $ | 2,438,977 | $ | 2,383,066 | $ | 2,304,440 | |||||||
Average Sales Per Location (c) |
||||||||||||
Zales |
$ | 1,383,000 | $ | 1,366,000 | $ | 1,390,000 | ||||||
Zales Outlet |
1,360,000 | 1,249,000 | 1,287,000 | |||||||||
Gordon’s |
1,200,000 | 1,112,000 | 1,101,000 | |||||||||
Bailey Banks & Biddle |
3,738,000 | 3,474,000 | 2,848,000 | |||||||||
Peoples |
1,397,000 | 1,140,000 | 1,041,000 | |||||||||
Piercing Pagoda |
332,000 | 343,000 | 339,000 | |||||||||
Peoples II |
82,000 | 100,000 | — |
| Locations By Brand | ||||||||||||
| Locations Opened During | Locations Closed During | Locations at End of | ||||||||||
| Period | Period | Period | ||||||||||
Year Ended July 31, 2006 |
||||||||||||
Zales (d) |
24 | 20 | 784 | |||||||||
Zales Outlet (d) |
7 | 1 | 131 | |||||||||
Gordon’s |
17 | 11 | 293 | |||||||||
Bailey Banks & Biddle |
1 | 32 | 73 | |||||||||
Peoples |
7 | — | 175 | |||||||||
Piercing Pagoda |
38 | 33 | 817 | |||||||||
Peoples II |
16 | 9 | 76 | |||||||||
Master Jewelry Repair |
3 | 3 | — | |||||||||
| 113 | 109 | 2,349 | ||||||||||
Year Ended July 31, 2005 |
||||||||||||
Zales |
24 | 14 | 767 | |||||||||
Zales Outlet |
18 | 1 | 138 | |||||||||
Gordon’s |
13 | 13 | 287 | |||||||||
Bailey Banks & Biddle |
— | 4 | 104 | |||||||||
Peoples |
6 | 1 | 168 | |||||||||
Piercing Pagoda |
50 | 36 | 812 | |||||||||
Peoples II |
71 | 2 | 69 | |||||||||
Master Jewelry Repair |
— | — | — | |||||||||
| 182 | 71 | 2,345 | ||||||||||
Year Ended July 31, 2004 |
||||||||||||
Zales |
9 | 7 | 757 | |||||||||
Zales Outlet |
25 | — | 121 | |||||||||
Gordon’s |
9 | 9 | 287 | |||||||||
Bailey Banks & Biddle |
— | 8 | 108 | |||||||||
Peoples |
5 | 9 | 163 | |||||||||
Piercing Pagoda |
24 | 39 | 798 | |||||||||
Peoples II |
— | — | — | |||||||||
Master Jewelry Repair |
— | — | — | |||||||||
| 72 | 72 | 2,234 | ||||||||||
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| (a) | Includes revenues of $24.3 million, $49.8 million, and $48.1 million for fiscal years 2006, 2005, and 2004, respectively, related to the Bailey Banks & Biddle store closings in the second quarter of fiscal year 2006. | |
| (b) | Peoples (including Mappins) and Peoples II reflects all revenue from Canadian operations, which constitutes all our foreign operations. Long-lived assets from foreign operations totaled approximately $29.3 million, $27.6 million, and $23.2 million at July 31, 2006, 2005, and 2004, respectively. | |
| (c) | Based on merchandise sales for locations open a full twelve months during the applicable year. | |
| (d) | In fiscal year 2006, the total locations at the end of the period reflect 13 stores that were moved from the Zales Outlet brand to the Zales brand. |
Business Segment Data
Information concerning sales and segment income attributable to each of our business segments is set forth in Item 6, “Selected Financial Data,” in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and in “Notes to Consolidated Financial Statements,” all of which are incorporated herein by reference.
Store Operations
Our stores are designed to differentiate our brands, create an attractive environment, make shopping convenient and enjoyable, and maximize operating efficiencies, all of which should enhance the customer experience. We focus on store layout, with particular focus on arrangement of display cases, lighting, and choice of materials to optimize merchandise presentation. Promotional displays are changed periodically to provide variety or to reflect seasonal events.
Each of our stores is led by a store manager who is responsible for store-level operations, including overall store sales and personnel matters. Administrative matters, including purchasing, distribution and payroll, are consolidated at the corporate level in an effort to maintain efficiency and low operating costs at the store level. In addition to selling jewelry, each store also offers standard warranties and return policies, and provides extended warranty coverage that may be purchased at the customer’s option. In order to facilitate sales, stores will hold merchandise in layaway, generally requiring a deposit of not less than 20 percent of the purchase price at the inception of the layaway transaction.
We have implemented inventory control systems, extensive security systems and loss prevention procedures to maintain low inventory losses. We screen employment applicants and provide our store personnel with training in loss prevention. Despite such precautions, we experience losses from theft from time to time, and maintain insurance to cover such external losses.
We believe it is important to provide knowledgeable and responsive customer service and we maintain a strong focus on connecting with the customer, both through advertising and in-store communications and service. Our goal is to service the customer from the first sale by maintaining a customer connection through client services. We have a centralized customer service call center to more effectively address customer phone calls at lower aggregate cost.
We continue to focus on the level and frequency of our employee training programs, particularly with store managers and key sales associates. We also provide training in sales techniques for new employees, on-the-job training for all store personnel and management training for store managers. Under the banner of Zale Corporation University, we offer training to employees at every level of the organization.
Purchasing and Inventory
We purchase the majority of our merchandise in finished form from a network of established suppliers and manufacturers located primarily in the United States, Southeast Asia and Italy. All purchasing is done through buying offices at our headquarters. As discussed in the section “Business Initiatives and Strategy,” a centralized product sourcing organization also has been established to coordinate the purchase and assembly of core diamond products such as solitaire rings, earrings and pendants. Consignment inventory has historically consisted of test programs, merchandise at higher price points or merchandise that otherwise does not warrant the risk of ownership. Consignment merchandise can be returned to the vendor
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at any time or converted to owned inventory if it meets certain productivity thresholds. We had approximately $175.1 million and $150.9 million of consignment inventory on hand at July 31, 2006 and 2005, respectively. During fiscal years 2006 and 2005, we purchased approximately 22 percent of our finished merchandise from our top five vendors, including more than six percent from one vendor in 2006. If our supply with these top vendors were disrupted, particularly at certain critical times during the year, our sales could be adversely affected in the short term until alternative supply arrangements could be established. During fiscal year 2006, our direct sourcing organization accounted for approximately six percent of our merchandise requirements.
In fiscal year 2006, we expanded our use of forward contracts for the purchase of our gold and silver in order to reduce the effects of fluctuating commodity prices. We generally hedge certain planned inventory purchases covering a designated period of no longer than twelve months and amounts consistent with our identified exposure. The purpose of hedging activities is to minimize the effect of commodity price movements on cash flows. All forward contracts are currently with four financial institutions rated as investment grade by a major rating agency. No fees or up front payments are required when using these commodity forwards. These contracts settle on a net basis.
As a specialty retail jeweler, we could be affected by industry-wide fluctuations in the prices of diamonds, gold, and other metals and stones. The supply and prices of diamonds in the principal world markets are significantly influenced by a single entity, the Diamond Trading Company, 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 to the Diamond Trading Company and our suppliers is to some extent dependent on the political situation in diamond-producing countries and on continuation of prevailing supply and marketing arrangements for raw diamonds. Until alternate sources are developed, any sustained interruption in the supply of diamonds could adversely affect us and the retail jewelry industry as a whole. The inverse is true with respect to any oversupply from diamond-producing countries, which could cause diamond prices to fall.
Within the jewelry industry there has been continued focus on “conflict diamonds,” which are allegedly extracted from war-torn regions and sold by organizations to fund insurrection. Through an international system of certification and legislative initiatives, the diamond trade has taken steps to ensure the exclusion from the supply chain of these diamonds, which represent a small fraction of the world’s supply. It is not expected that such efforts, if successful, will substantially affect the supply of diamonds. However, in the near term, efforts by non-governmental organizations to encourage legislative response combined with an upcoming movie about conflict diamonds scheduled for national release in December 2006 could increase consumer awareness of the issue and could affect consumer demand for diamonds.
Proprietary Credit
Our private label credit card program helps facilitate the sale of merchandise to customers who wish to finance their purchases rather than use cash or other payment sources. We offer revolving and interest free credit programs under our private label credit card program. Approximately 41 percent and 44 percent, respectively, of our U.S. total sales excluding Piercing Pagoda, which does not offer proprietary credit, were generated by proprietary credit cards in fiscal years 2006 and 2005. Our Canadian propriety credit card sales represented approximately 27 percent of Canadian total sales for fiscal year 2006 and approximately 29 percent of Canadian total sales in fiscal year 2005.
In fiscal year 2006, we continued our proprietary credit offerings of same-as-cash, revolving and interest free programs, all of which allowed our sales personnel to provide the customer additional financing options.
In July 2000, we entered into a ten-year agreement with Citi whereby Citi issues private label credit cards branded with appropriate trademarks, and provides financing for our customers to purchase merchandise in exchange for payment by us of a merchant fee based on a percentage of each credit card sale. The merchant fee varies according to the credit plan that is chosen by the customer (i.e., Revolving, Interest Free, Same as Cash).
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Employees
As of July 31, 2006, we had approximately 16,900 employees, approximately 10 percent of whom were Canadian employees and less than one percent of whom were represented by unions. We usually hire temporary employees during each Holiday season.
Seasonality
As a specialty retailer of fine jewelry, our business is seasonal in nature, with our second quarter, which includes the months of November through January, typically generating a proportionally greater percentage of annual sales, earnings from operations and cash flow than the other three quarters. We expect such seasonality to continue.
Information Technology
Our technology systems provide information necessary for (i) store operations; (ii) sales and margin management; (iii) inventory control; (iv) profitability monitoring by many measures (merchandise category, buyer, store); (v) customer care; (vi) expense control programs; and (vii) overall management decision support. Significant data processing systems include point-of-sale reporting, purchase order management, replenishment, warehouse management, merchandise planning and control, payroll, general ledger, sales audit, and accounts payable. Bar code ticketing and scanning are used at all point-of-sale terminals to ensure accurate sales and margin data compilation and to provide for inventory control monitoring. Information is made available online to merchandising staff on a timely basis, thereby increasing the merchants’ ability to be responsive to changes in customer behavior. We are also improving the connectivity between stores and our corporate headquarters to enhance operating efficiencies and speed of transmission.
Our information technology systems and processes allow management to monitor, review and control operational performance on a daily, monthly, quarterly and annual basis for each store and each transaction. Senior management can review and analyze activity by store, amount of sale, terms of sale or employees who sell the merchandise.
We have a data center operations services agreement with a third party for the management of our mainframe processing operations, client server systems, Local Area Network operations, Wide Area Network management and e-commerce hosting. The agreement, effective August 1, 2005, requires fixed payments totaling $30.0 million over an 84-month period plus a variable amount based on usage, and extends through 2012. We believe that by outsourcing our data center operations, we are focusing our resources on developing and enhancing the strategic initiatives discussed in the Business and Strategy section.
We have historically upgraded, and expect to continue to upgrade, our information systems to improve operations and support future growth. We estimate we will make capital expenditures of approximately $8 million in fiscal year 2007 for enhancements to our information systems and infrastructure.
Regulation
Our operations are affected by numerous federal and state laws that 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. In addition to our private label credit cards, credit to our customers is provided primarily through bank cards such as Visa®, MasterCard®, and Discover®. Any change in the regulation of credit which would materially limit the availability of credit to our traditional customer base could adversely affect our results of operations or financial condition.
We are subject to the jurisdiction of various state and other taxing authorities. From time to time, these taxing authorities conduct reviews or audits of the Company.
The sale of insurance products by us is also highly regulated. State laws currently impose disclosure obligations with respect to our sale of credit and other insurance. In addition, our sale of insurance products
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in connection with our private label credit cards appears to be subject to certain disclosure and other requirements under the Gramm-Leach-Bliley Act of 1999. Our and our competitors’ practices are also subject to review in the ordinary course of business by the Federal Trade Commission and our and other retail companies’ credit cards are subject to regulation by state and federal banking regulators. We believe that we are currently in material compliance with all applicable state and federal regulations.
Merchandise in the retail jewelry industry is frequently sold at a discount off the “regular” or “original” price. We are subject to federal and state regulations requiring retailers offering merchandise at promotional prices to offer the merchandise at regular or original prices for stated periods of time. Additionally, we are subject to certain truth-in-advertising and various other laws, including consumer protection regulations that regulate retailers generally and/or the promotion and sale of jewelry in particular. We monitor changes in those laws and believe that we are in material compliance with applicable laws with respect to such practices.
Available Information
We provide links to our filings with the Securities and Exchange Commission (“SEC”) and to the SEC filings (Forms 3, 4 and 5) of our directors and executive officers under Section 16 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), free of charge, on our website at www.zalecorp.com , under the heading “SEC Filings” in the “Shareholder Information” section. These links are automatically updated, so the filings also are available immediately after they are made publicly available by the SEC. These filings also are available through the SEC’s EDGAR system at www.sec.gov.
Our certificate of incorporation and bylaws as well as the charters for the compensation, audit, nominating and corporate governance committees of our Board of Directors and the corporate governance guidelines are available on our website at www.zalecorp.com , under the heading “Corporate and Social Responsibility.”
We have a Code of Business Conduct and Ethics (the “Code”). All of our directors, executive officers and employees are subject to the Code. The Code is available on our web site at www.zalecorp.com , under the heading “Corporate and Social Responsibility-Code of Business Conduct and Ethics.” Waivers of the Code for directors and executive officers will be disclosed in a SEC filing on Form 8-K.
ITEM 1A. RISK FACTORS
We make forward-looking statements in the Annual Report on Form 10-K and in other reports we file with the 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, sales and earnings, merchandising and marketing strategies, store opening, renovation, 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, e-commerce initiatives, human resource initiatives, impact of the Bailey Banks & Biddle store closings 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.
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If the general economy performs poorly, discretionary spending on goods that are, or are perceived to be “luxuries” may not grow and may even 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 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.
Most of our sales are of products that include diamonds, precious metals and other commodities, and fluctuations in the availability and pricing of commodities could impact our ability to obtain and produce 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. In the near term, efforts by non-governmental organizations to encourage legislative response combined with a movie about conflict diamonds scheduled for national release in December 2006 could increase consumer awareness of the issue and could affect consumer demand for diamonds.
We are also affected by fluctuations in the price of diamonds, gold and other commodities. We historically have engaged in hedging against fluctuations in the cost of gold. 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.
Our sales are dependent upon mall traffic.
Our stores, kiosks, and carts 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.
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, mass merchandisers and catalog showrooms. We also are beginning to 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.
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Any failure by us to manage our inventory effectively will negatively impact sales and earnings.
We purchase much of our inventory well in advance of each selling period. In the event we misjudge consumer preferences or 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.
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 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. Further, 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.
Changes in regulatory requirements relating to the extension of credit may increase the cost of or adversely affect our operations.
Our operations are affected by numerous U.S. and Canadian federal and state or provincial laws that impose disclosure and other requirements upon the origination, servicing and enforcement of credit accounts and limitations on the maximum aggregate amount of finance charges that may be charged by a credit provider. Any change in the regulation of credit (including changes in the application of current laws) which would materially limit the availability of credit to our customer base could adversely affect our sales and earnings.
Any disruption in, or changes to, our private label credit card arrangement with Citi may adversely affect our ability to provide consumer credit and write credit insurance.
Our agreement with Citi, through which Citi provides financing for our customers to purchase merchandise through private label credit cards, enhances our ability to provide consumer credit and write credit insurance. Any disruption in, or change to, this agreement could have an adverse effect on our business, especially to the extent that it materially limits credit availability to our customer base.
Acquisitions involve special risk, including the possibility that we may be unable to integrate new acquisitions into our existing operations.
We have made significant acquisitions in the past and may in the future make additional acquisitions. 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 customer reach, and/or other projected benefits from the acquisition. Additionally, attractive acquisition opportunities may not be available at the time or pursuant to terms acceptable to us.
We recently appointed a new CEO, who may initiate strategies or other changes in store levels, expenses, staffing, and related matters.
Mary E. Burton was named Acting Chief Executive Officer in January 2006 and President and Chief Executive Officer in July 2006. As discussed under “Business Initiatives and Strategy,” we have a number of strategy initiatives and expect Ms. Burton to initiate others. Each of these initiatives will require the commitment of capital and human resources. These initiatives may or may not generate the expected results.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
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