Zale F3Q07 (Qtr End 4/30/07) Earnings Call Transcript

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Zale Corporation (ZLC)
F3Q07 Earnings Call
May 22, 2007 9:00 am ET

Executives

Betsy Burton - President & CEO
Rodney Carter - CFO
Cindy Gordon - Controller
David Sternblitz - Treasurer

Analysts

Connie Wong - Cowen & Company
Evren Kopelman - J.P. Morgan
Julie Chapgier - Merrill Lynch
Bill Armstrong - CL King & Associates
Melissa Otto - W.R. Hambrecht
David Mann - Johnson Rice
Jeff Stein - KeyBanc Capital Markets
Marc Bettinger - Stanford Financial Group

Presentation

Operator

Good morning. My name is Ashley, and I will be your conference operator today. At this time, I would like to welcome everyone to the Zale Corporation Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session (Operator Instructions).

I will now turn the call over to Ms. Betsy Burton, President and Chief Executive Officer. Ma'am, you may begin your conference.

Betsy Burton

Good morning, and thank you for joining us for our third quarter conference call. I am Betsy Burton, Chief Executive Officer of Zale Corporation. With me on the call today are Rodney Carter, Chief Financial Officer; Cindy Gordon, Controller; and David Sternblitz, Treasurer. Before we begin, Rodney will review the Safe Harbor.

Rodney Carter

Our commentary and responses to your questions on this conference call will contain forward-looking statements, including statements relating to our future goals, plans, and objectives. These 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 respected results in these forward-looking statements.

Information concerning some of the factors that could cause actual results to differ materially from those contained in the forward-looking statement is available in our annual report on Form 10-K for the year ended July 31, 2006 and our quarterly report on Form 10-Q for the quarter ended January 31st, 2007 as filed with the SEC.

In addition, we may present financial information on this call that would be considered non-GAAP financial information. For your reconciliation of each non-GAAP financial measure to the most directly comparable GAAP financial measure, please refer to the company's most recent sales and earnings release, which can be found on our website www.zalecorp.com under Financial Information and then News Releases.

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Betsy Burton

Thank you, Rodney. Q3 results were in line with revised expectations. While comp store sales decreased 3.4%, our focus on maximizing gross margin dollars and expense saves resulted in earnings at the high end of guidance or EPS of $0.05 when you exclude the impact of derivative accounting and the change to a lifetime jewelry protection plan. Here is some of the highlights for the quarter.

The Zales brand had a mid-single digit comp decrease, due to a decline in number of transactions, offset by an increase in average ticket. We believe this is consistent with the decline in overall mall traffic and similar to the high-single digit decline in number of transactions for our other mall-based moderate brands.

And while the Gordon's brand had a mid single digit comp decrease for the quarter, we are encouraged by a positive trend post Easter due to the arrival of improved assortments in bridal and diamond fashion. Gordon's also experienced a nice pickup in gross margin as a result of a less promotional customer appreciation event and better coordination with the Zales brand.

Pagoda also experienced a mid single digit decline in comp sales, driven by a high single digit decline in number of transactions, offset somewhat by an increase in average ticket. Gold represents 75% of the drop in sales, due in large part to the consumer resistance to price increases in gold chain as a result of rising commodity costs. We also have taken steps to increase the number of units in mid price point chains, $59 to $199, and are testing new diamond product, as well.

Bailey, Banks, and Biddle, had a low single digit comp decrease driven entirely by a decline in average ticket. This trend has since reversed and we are seeing good results from the new I-1 solitaire program, as well as continuing strength in designer and high-end watches.

Outlet comps were essentially flat, although gross margin dollars and operating earnings increased as a result of improved margin rate and mix. A decline in number of transactions was entirely offset by an increase in average ticket. The change in average ticket is due primarily to fewer transactions under $500, and increasing sales of higher ticket products. We continue to see particular strengths in the power center stores as well as new stores that are performing substantially over plan.

Peoples and Mappins in Canada again are a bright spot. Comp sales increased in the high single digits and total revenues are up in the mid teens. Both number of transactions and average ticket increased. And was primarily driven by diamond fashion, diamond accent, and gold.

In addition, gross margin rate increased 50 basis points over last year due to direct importing of diamond fashion and the elimination of the Canadian excise tax. Also, as previously announced, we closed two-thirds of the Peoples Two carts during the quarter. The remainder of the carts we'll close by the end of the fiscal year.

Another bright spot was dotcom. Sales were up over 50% versus last year. Traffic was up 20% and conversion was up 30%. During April, we launched Gordon's website and we also converted to a pick from one bin in the DC, resulting in a strong pickup due to access to all brands used.

Other notable events during the quarter. We generated an incremental $10 million in cash from the lifetime jewelry protection plan in Q3 and over $25 million year-to-date. We are now projecting the change to lifetime to generate an incremental $35 million in cash for the current fiscal year. Year-to-date sales of direct sourced goods have increased from 26% last year to 35% this year. Sales of direct source loose diamond products have more than doubled year-over-year from 4.3% to 8.6%.

During third quarter, we tested various pricing and promotion strategies at Zales and we see some opportunities for changes during Q4, as we go into the new fiscal year and look to optimize gross margin dollars. We have moved from about 20% to 30% SKUs in common between Zales and Gordon's. Our goal is to reach 50 to 60% by holiday. This is a critical step as we lay the foundation for the transition to a centralized merchandising organization.

In addition, we completed the development and testing of the new Oracle retail demand forecasting and item planning application. This automates what is currently a very cumbersome manual process and should be fully implemented for the placement of holiday orders.

Let's now talk about Mother's day. As you know, Mother's Day is key to the quarter. Here is a preliminary look at how we did. Trends at Zales and Pagoda did not change significantly at Mother's Day. Gross margin dollars helped offset decrease in comps, but these brands continue to deleverage SG&A.

Gordon's trend is improving. They experienced flattish comps with improvement in gross margin rates versus last year. Outlet had low single-digit positive comps, due primarily to an increase in average ticket.

Power center comps were up double-digits, and the only group with negative comps were the destination stores. And Outlet's margins were up 110 basis points over last year and 40 basis points over plan. Bailey, Banks and Biddle had a very strong Mother's Day. Comp sales were up mid-single-digits, and gross margin rate exceeded plan by 200 basis points. Peoples again was a bright spot. Comp sales were up high single-digits and gross margin rate continued to improve. And last, dotcom continued its strong performance with sales up 42% over last year.

On to our challenges for Q4. It is a challenging macro environment. Retail and jewelry retailing in particular is tough. We believe higher gas prices have directly impacted the discretionary income of the moderate customer. We also see that the low end of our outlet business has been impacted. Transactions below $500 are down. However, larger solitaire carat weights are showing double-digit growth.

And while the power center stores are experiencing double-digit positive comps, destination centers are the only group with negative comps as it appears gas prices are causing consumers to be less willing to drive further to shop. We need to continue to focus on the balance between top line sales growth and maximizing gross margin dollars.

We also have more inventory in the Zales brand than we would like. We have about $70 million of excess inventory in program goods, items that are part of our go-forward assortments. We will correct this situation, primarily by scaling back replenishment of these items in the DC. And we still have about $40 million of clearance inventory with reserves that we need to move through without trading regular sales and without negatively impacting margins.

We are addressing both of these through various initiatives. Sharing of program inventory with Gordon's as we move further toward alignment of SKUs and moving clearance through Canada and dotcom. We reduced inventory by over $30 million in Q3. Our goal is to reduce inventory even further by $50 to $70 million in Q4.

So for Q4, our focus continues to be maximizing gross profit dollars and expense reduction. Q4 is a relatively insignificant quarter in terms of sales and earnings, and we remain focused on the importance of Q2 and holiday to the success of fiscal '08. We will continue to work projects and changes near term that will have a positive impact long-term.

For Q4, we are lowering our projection for sales to a negative 2 to negative 3% comp. And while we remain cautious, we are maintaining current guidance of pro forma EPS in the range of minus $0.01 to minus $0.05.

I'd now like to ask Rodney to review the financials and then we will open up the call to questions.

Rodney Carter

Following are the key statistics for the third quarter of fiscal 2007. Comp store sales decreased 3.4% for the quarter. Peoples continued strong performance and Outlet was flat. The remaining brands had decreases in the low-to-mid single digits.

Total revenues decreased 2.9% for the quarter and were flat year-to-date. Total revenues for the quarter were negatively impacted by a decrease of $8.7 million in recognized revenues from the sale of lifetime jewelry protection plans or JPPs. Actual sales of JPPs increased to $28 million versus $18 million in the third quarter last year.

The average transaction for the quarter by brand was as follows. Zales, this year at $367 versus last year of $341. Gordon's, $411 versus last year of $400. Bailey Banks & Biddle, $1724 versus $1763 in the prior year. Outlet, $427 versus $414 last year. Peoples, $301 versus $283 in the prior year. Pagoda at $38 versus $37 in the prior year.

Discussed in our second quarter call, we altered the service period from two years to the lifetime of product ownership for the jewelry protection plans offered to our customers on merchandise purchases while simultaneously raising the retail price on the plans. The customer response was favorable, as our attachment rate went from 43% to 54% on applicable product and sales at the stores increased $10 million during the quarter compared to last year.

While sales at the stores increased, revenue recognized were negatively impacted as the company changed from a proportionate two year recognition period based on the historical service patterns for the two-year protection plan to a straight line amortization period over five years for the new lifetime protection plan. The estimated impact to the third quarter is $11.3 million in reduced recognized revenue.

For the year, total sales of JPPs have increased $25.6 million to $87.6 million from $62 million for the year-to-date periods. Revenue recognized has decreased $18.7 million from $55.2 million to $36.5 million in the same period.

The $18.7 million of sales that have not been recognized will result in increased revenues during fiscal 2008 through 2012. While the impact on recognized revenues from the product changes has a negative impact on current earnings per share, given the 40% increase in product sales, we're going to continue to sell the lifetime JPP.

Because fiscal 2007 earnings estimates were based on sales of our two-year agreement, we believe it will continue to be meaningful to investors to reconcile our fiscal '07 results under GAAP with the estimated impact of revenue recognition for JPPs on a basis consistent with our historical methodology.

We will also continue to disclose gross sales of service agreements in order to keep everyone aware of the continued cash generated from these sales that are not yet recorded as revenue. As I further discuss operating results, I will reference both with and without the impact of revenue recognition.

In the summer of 2006, the company entered into contracts for the purchase of gold and silver to offset potential fluctuations in the purchases of inventory and the impact of retail pricing strategies. For accounting purposes, these contracts have been reflected in earnings each quarter based on the actual gain and losses, if settled or based on current values if still outstanding.

Our guidance was based upon these contracts under hedge accounting. Under hedge accounting, we would have reflected the contract gains and losses in cost of sales as the inventory was sold. For example, we recognized a $155,000 gain in the quarter, and a $7 million loss year-to-date. Under a basis consistent with our guidance, we would have had an additional cost of sales of $2.4 million in the quarter and $6 million year-to-date. As the majority of contracts have settled, we expect the impact to be approximately $1 million to $2 million to cost of sales in the fourth quarter.

Gross margin declined from 51.7% to 51%. Positive merchandise margin gains from direct sourcing and less promotional activities were offset by the decline in revenue recognized for lifetime JPPs. SG&A, including the cost of insurance operations was 47.7% for the quarter versus 45.8% last year as a percentage of revenues.

The increase was primarily a result of the inability to leverage increased store operating occupancy expenses and promotional investments on a decline in comparable store sales and $11.3 million reduction in recognized revenues from lifetime service agreements. At the same time, we did exercise a disciplined approach to store payroll and other controllable expenses to reduce the degree of deleverage.

Operating loss for the quarter was $622,000 versus earnings of $28.1 million last year. Prior year amounts include $13.4 million benefit from settlement of a retirement plan and $5.1 million of severance in Bailey Banks & Biddle store closing costs.

Operating earnings for the quarter on a basis consistent with guidance and prior years, including hedge accounting for commodity contracts and accelerated revenue recognition from the sales of JPP were $8.1 million, or 1.6% as a percent of sales versus $19.7 million last year, or 3.7%, excluding the impact of retirement plan benefit and severance store closing expenses.

The effective tax rate for the quarter was 38.3% versus 34.3% last year. Last year the effective tax rate included a tax repatriation benefit in the quarter.

Under GAAP, the net loss for the quarter was $3.1 million or $0.06 per share versus net income of $16.8 million or $0.35 per share last year. Net income for the quarter under hedge accounting and including the estimated revenue recognized on a basis consistent with historical results was $2.6 million or $0.05 per share versus net income of $11.6 million or $0.24 per share last year. Excluding the benefit from the settlement of retiree benefit obligation, severance costs, and charges for the Bailey Banks & Biddle closed stores.

During the quarter, we opened 11 stores and one kiosk. We closed 13 stores and 60 kiosks, principally People Two carts in Canada. We've remodeled and refurbished 19 stores and 10 kiosks in the quarter. We ended the quarter with 2,292 locations as follows: Zales, 787; Gordon's, 284; Bailey Banks & Biddle, 72; Outlet, 137; Peoples, 189; Peoples Two, 26; and Pagoda at 797.

The capital expenditure plan is approximately $95 million for the fiscal year with a total target of 53 new jewelry stores, primarily in People's, Zales, and Outlet brands and nine new Piercing Pagoda kiosks.

Merchandised inventory at April 30th, 2007 was $1.1 billion or $148 million and 15.8% higher than last year's level at $938 million. The increase in inventory is consistent with the second quarter. The Zales brand has approximately $40 million remaining in clearance merchandise identified at year-end.

We continue to focus on clearing out this inventory, including leveraging the other brand's capacity where appropriate. In addition, the brand has $70 million related to inventories to drive previous holiday and future sales. While we remain committed to reducing inventory levels going forward, we believe the investments to be in items that are consistent with the brand positioning and represent items with solid sell through.

As a final note, $20 million of the increase is attributable to our diamonds direct sourcing operation. Inventory turnover on a rolling 12-month basis was 1.14 times, versus 1.26 times last year. The decline is reflective of the increased investments. Accounts payable and accrued liabilities are $39 million lower than April 30th, 2006, primarily attributable to the decline in current merchandise payables as the brands work through existing overstock items, lower income taxes payable, and reduction in liabilities due to the settlement of Bailey, Banks & Biddle lease obligations and severance in the prior year.

We ended the quarter with $53 million in cash and borrowings of $290 million under a line of credit compared to $60 million in cash and borrowing of $205 million last year. The result of the increased inventory levels and the decline in current receipts and merchandise payables is both increased borrowings and a significant reduction in free operating cash flow. We estimate fiscal 2007 free cash flow to be in the range of a negative $70 to $80 million.

As Betsy stated, our updated estimates for the fourth quarter are for comparable store sales declines of negative 2% to 3%. As we continue to expect pro forma earnings per share, of negative $0.01 to negative $0.05. These estimates include or exclude the impact of a change in revenue recognition and the treatment of contracts under hedge accounting.

As we look to the balance of this fiscal year and into fiscal '08, we will be concentrating on opportunities to return to a position of positive cash flow and focus on driving profitable sales, controlling expenses, and spending capital in a very disciplined fashion. David and I will be available to discuss any details after the call.

We will now open the call for questions.

Question-and-Answer Session

(Operator Instructions) Your first question comes from Lauren Levitan with Cowen & Company.

Connie Wong - Cowen & Company

This is actually Connie Wong calling in for Lauren Levitan. I know a main focus of yours has been to grow gross profit dollars. I was wondering if you guys could give us an update on your direct sourcing initiative to improve overall gross margin? Thank you.

Betsy Burton

Sure. Hi, Connie, we have made good progress in direct sourcing. And as I alluded, if you look at this time year-to-date last year, our total direct sourcing was about 26.5% of our total sales. And this year, it's about 35%. So substantive increases, obviously in terms of our diamond sourcing operation has doubled from 4.3% to 8.6%.

The largest increase really is in the Zale brand. And it went from about the diamond direct sourcing went from about 1.5% last year to about 10 -- a little bit in excess of 10% of sales for this year. So tremendous progress made in the Zale brand. And in terms of our merchandise margins, we have seen the improvement, however it's been somewhat offset by some of the commodity price increases.

Connie Wong - Cowen & Company

And do you guys have like a long-term target then for you guys want the total direct sourcing to be at if it's at 36% right now?

Betsy Burton

Sure. We believe that the direct -- the diamond direct sourcing should approximate 20% of our total sales. And an additional 30% in terms of direct imports. So we believe conservatively 50% of our total sales.

Connie Wong - Cowen & Company

Okay. Great. And then -- and another question on inventory levels. I know that you guys -- looks like you guys were up about 16% overall and you had talked about decreasing that going forward. Do you guys have any targets for inventory per store going forward? What we can expect for Q4 and maybe next year?

Betsy Burton

Yes, we believe the real inventory reduction will come from what we call our DC replenishment. We pretty much right size our stores post holidays. Any merchandise in excess of what would be considered a normal per-store level would have been stock balanced and brought back into the DC. So the big reduction in inventory will be by not receiving additional goods into the DC.

Connie Wong - Cowen & Company

Okay. Great. Thank you.

Betsy Burton

Thank you.

Operator

Your next question comes from Brian Tunick with J.P. Morgan.

Evren Kopelman - J.P. Morgan

Good morning. This is Evren Kopelman for Brian. First question is you have mentioned previously that one of the reasons behind your success in Canada is your unique position in terms of market share leadership; having a 20% market share helps. And about a year ago you thought a possible combination with your major competitor in the U.S. was not in the best interest of your shareholders. So we're just curious what are your thoughts today? And what are some of the factors you consider when thinking about a potential combination?

Betsy Burton

I have always felt that and have always said that there are obviously very compelling synergies, in terms of a combination. For lots of reasons that I'm really not at liberty to go into details why we did not believe it was in the best interest of shareholders at the time when we were in discussion last year. But I have always said that we are open to entertaining any possible options.

Evren Kopelman - J.P. Morgan

And secondly, do you have any thoughts -- are you happy with the portfolio of businesses you have today? Do you have any thoughts on selling or spinning off any divisions?

Betsy Burton

Yes, we actually have conducted a fairly extensive portfolio review. And unfortunately, I am not at liberty to discuss where we're at in some of those discussions. But it is certainly something that we have considered.

Evren Kopelman - J.P. Morgan

And then finally, you had mentioned on the last conference call you were testing maybe a regional pricing strategy for Mother's Day, I believe at the Zales brand. Can you give us an update on that?

Betsy Burton

Right. Sure. Sure. Yes, we tested, if you were to take our 9 regions, we took 3 regions and used them as a control group and tested various combinations of pricing and promotion strategy. And we have -- we believe we have refined our pricing strategy, although for competitive reasons I'm really not at liberty to discuss. But we feel comfortable that we see the opportunities to enhance our pricing strategy.

Evren Kopelman - J.P. Morgan

Thank you.

Betsy Burton

Sure.

Operator

Your next question comes from Julie Chang.

Betsy Burton

Good morning, Julie. Operator? Operator? Hello?

Operator

Your next question comes from Julie Chapgier with Merrill Lynch.

Betsy Burton

Good morning, Julie.

Julie Chapgier - Merrill Lynch

Good morning. So last quarter you said you were expecting to warranties to be about a $0.15 drag on EPS for the fourth quarter. And so the guidance is now $0.12. Are you selling less or have you changed the accounting? Or what caused this change?

Rodney Carter

It's very -- still very close, within a $0.01 of the range. And obviously part of the estimate, Julie is what sales are and with sales being down a little bit. It was down slightly. It's very close to the range that we had previously given.

Julie Chapgier - Merrill Lynch

So it's not a change in any of the accounting or anything like that?

Rodney Carter

That is correct.

Julie Chapgier - Merrill Lynch

And have you guys looked at maybe being able to split the warranty into 2-year versus lifetime so that you can account -- so you can recognize the revenue for the 2-year part earlier?

Betsy Burton

We actually did look at it. And we have had multiple conversations with not just our auditors, but also with the SEC. And we believe that, first of all, we believe that the lifetime product is the best product and from an operational standpoint, clearly it is the best product for the consumer and the consumer has responded favorably. The hurdle that we would have to achieve in terms of selling 2-year if we offered both 2-year and a lifetime extension is substantial. And we felt that it would not be the right operating decision. So we have made the decision to continue with offering the life, only the lifetime and accepting the fact that we will have to continue to explain the straight lining of the revenue recognition.

Julie Chapgier - Merrill Lynch

Okay. Great. And then, just how did you address the previous cannibalization between the Gordon's and Zales during Mother's Day? And will you be carrying forward any of those strategies for holiday?

Betsy Burton

Yes, in fact, part of the results, we were very pleased with the results at Gordon, because we did coordinate promotions, strategies, and felt very good. And again, if you look at the quarter, the same thing that happened in Q3, we believe that our real opportunity is to optimize gross margin dollars.

So I think we are very pleased, I think again, the better coordination of pricing and promotion resulted in better results for both the Zale's brand and the Gordon's brand in terms of gross margin dollars. And yes, we will continue to roll with that strategy for holiday.

Julie Chapgier - Merrill Lynch

Thank you.

Betsy Burton

Sure.

Operator

Your next question comes from Bill Armstrong with CL King & Associates.

Bill Armstrong - CL King & Associates

Good morning. On your guidance, you're lowering your sales assumption but maintaining your earnings guidance. So, that would imply some improvement versus your previous expectations either in gross margin or SG&A or some combination. Could you just elaborate in that, please?

Betsy Burton

Yes, we continued to look at the same results that we experienced in Q3 where we had similar results in terms of Mother's Day as Valentine's. And because of our focus on gross margin dollars, we're able to pick up gross margin dollars, which flows through to the bottom line and on top of that, we are focused on expense control.

So the combination of the two would suggest that given the macro environment, this is not the year to go after sales. So, instead we're going after gross profit dollars and again expense saves.

Bill Armstrong - CL King & Associates

Are there any particular areas of the expense line that you're seeing some opportunities to reduce?

Betsy Burton

The biggest line is obviously payroll. But again, a lot of also is better disciplines in terms of adherence to some of our merchandise policies and procedures. So I think tightening up on some of those disciplines, store payroll, especially in terms of hours of coverage are the easiest most visible changes.

Bill Armstrong - CL King & Associates

Okay. With the slight $0.02 reduction in the impact from the jewelry protection plan, I know it's at least partially due to a lower sales outlook. Any change in the assumed attachment rate?

Betsy Burton

We still assume the same attachment rate. No other changes in terms of our pricing strategy. There's really no change from prior.

Bill Armstrong - CL King & Associates

Okay. And then finally, in your earlier comments you said you plan to reduce inventories I think by $50 million to $70 million in the quarter?

Betsy Burton

Correct.

Bill Armstrong - CL King & Associates

Is that versus a year ago or versus April 30th?

Betsy Burton

Versus April 30th.

Bill Armstrong - CL King & Associates

Okay. Thanks very much.

Betsy Burton

Okay. Thank you.

Operator

Your next question comes from Melissa Otto with WR Hambrecht.

Betsy Burton

Good morning, Melissa.

Melissa Otto - W.R. Hambrecht

Hi, good morning. Just a question on the decreased sales forecast or projections for Q4. Can you give us specifically what brands in your portfolio you're expecting softer sales from?

Betsy Burton

Clearly, I think the brands that have the softest sales are the Zale brand and the Pagoda brand. And we believe, again, that that is primarily the moderate customer that has been impacted by high gas prices. We're not -- we see peoples again as a bright spot, we see outlet has having good sales, positive comps, and we believe Bailey's is off to a strong start for the quarter. And we do believe we've seen a good shift in trend at Gordon's. So, I would say again, the weakest brands would be Zale and Pagoda.

Melissa Otto - W.R. Hambrecht

Great. Would you elaborate on, I guess the correlation between gas prices and the brands and how does it impact the Zale customer and not impact the outlet customer?

Betsy Burton

Sure. Let's focus on the outlet customer first. We believe the outlet customer is a slightly more affluent customer. And it also, we believe it is more of a female self-purchaser. And if you look at the range, let's say at the range for a Zale customer would be household income of 40 to 75. We believe at outlet it's more like 40 to 100,000.

We do believe that the customer at the low end of that range for the outlet stores has been impacted by the price of gas as we have seen transactions under $500 fall off. So, we do believe that is the same phenomenon that's affecting the Zales and the Pagoda brands in terms of that customer is having to spend more of the disposable income on gas.

We also believe, again, if you look at the outlet stores and you dissect it, every part of the business is very healthy with the exception of the destination stores. And this is the first negative decline that they've had. And I believe that you could directly link that to the fact that people are feeling the pinch of higher gas prices.

Melissa Otto - W.R. Hambrecht

Thank you. That's very helpful. And just one final, just a quick question on the numbers. Was there an estimate for the derivative gain or loss for the Q4? How should we be thinking about that?

Rodney Carter

Yeah, it's between $0.01 to $0.02. I mean, $1 to $2 million.

Melissa Otto - W.R. Hambrecht

$1 million to $2 million. And does that translate into $0.01 to $0.02?

Rodney Carter

More like $0.02.

Melissa Otto - W.R. Hambrecht

Okay. Great. Thank you very much.

Betsy Burton

Thank you.

Operator

Your next question comes from David Mann with Johnson Rice.

David Mann - Johnson Rice

Yes, good morning Betsy and Rodney.

Betsy Burton

Good morning.

David Mann - Johnson Rice

My question goes back to your comment on the portfolio review that you're doing. Can you give a sense on what kind of timing we would expect you to complete that by? And also are you using any third parties to help you with that?

Betsy Burton

Hard to predict the timing. And, yes, we're using a third party. But I think that's about as specific as I can really get.

David Mann - Johnson Rice

Okay. And in terms of, if we're looking at the different brands in the portfolio, can you give us a sense with your, including your fourth quarter guidance what the EBIT margins by divisions might look like?

Betsy Burton

We really don't break them out by divisions, clearly for competitive reasons. But obviously that is a factor in our review, in other words it's not just what our considered noncore assets. But we obviously would be looking at what kind of return those particular brands provide to the company, especially as we look at a more disciplined approach to our investment of our capital.

David Mann - Johnson Rice

Okay. When you're looking at the whole portfolio, can you give us a sense of the 23,00 stores? How many of them are perhaps losing money on a four-wall or at least struggling to make money?

Betsy Burton

We don't believe we have a looming group of stores that are losing money. I think clearly, I think over the past years, I mean, we weeded out the ones that you would consider underperforming stores. So, we do not believe that this is about closing a lot of underperforming stores. Neither do we believe that it's about selling off a brand that has a substantial number of underperforming stores. As I said, I think we're pretty clean.

David Mann - Johnson Rice

Okay. And on what you're doing with payroll. When you look at sort of what you laid out as your strategy in terms of using an increase in payroll to drive training and build out your employee base. Can you sort of refresh where you stand now given that it sounds like you're stepping back a little bit on payroll to keep expenses tight?

Betsy Burton

Okay. Actually, we have upped the investment in training. So we are not touching the training budgets. We have, if anything, added money to the training budgets. It's really about just overall coverage, in other words, number of people that you open and close the store with, being prudent in terms of scheduling to make sure you schedule when the customers are there. So it's just a mor0e disciplined approach to payroll based off of the sales trends.

David Mann - Johnson Rice

And are there any metrics in terms of what you're doing on training that you feel are giving you some hope that this is the right way to go whether it be in terms of reduced turnover or any particular tests that you've done to drive sales?

Betsy Burton

We are seeing very positive returns. We're taking some of the training programs that were developed and rolled out in Canada and have brought them to the states. And it's really pretty hard to put a metric to the training. I think it's an intangible. And it’s also takes years for you to really get to the point where it pays off. So I think we're looking at training more as an investment than an immediate return.

David Mann - Johnson Rice

Okay. Thank you.

Betsy Burton

Thank you.

Betsy Burton

Thank you.

Operator

Your next question comes from Jeff Stein with KeyBanc Capital Markets.

Jeff Stein - KeyBanc Capital Markets

Couple questions for Rodney. First of all, Rodney, in the fourth quarter the hedge charge or benefit, I guess my first question. Are you looking for a charge or a benefit in the fourth quarter?

Rodney Carter

It's a charge.

Jeff Stein - KeyBanc Capital Markets

With respect to your cash flow, I think you indicated you're expecting $70 to $80 million of negative cash flow this year. Is that correct?

Rodney Carter

Correct.

Jeff Stein - KeyBanc Capital Markets

Wondered if you could kind of call out some key components to that negative swing? When I look at my model, I'm having trouble coming up with that kind of number. For example, working capital, can you give us a guesstimate in terms of what you expect your working capital growth to be this year?

Rodney Carter

I don't have the working capital directly in front of me. But what I would tell you is some of the key drivers of this, obviously the inventory investment on a year-over-year basis.

Jeff Stein - KeyBanc Capital Markets

Right.

Rodney Carter

The lower sales and profitability, the increase investment, both in the brands as well as the direct sourcing. And because we're using overstock merchandise out of the DC to do this, we have far less in merchandise payables.

Jeff Stein - KeyBanc Capital Markets

Got it.

Rodney Carter

Those are the three that really are driving this thing. And some of the other changes that went through, some of the working capital calculations is year-over-year we had a big tax receivable floating in and out. We could go for a reconciliation, but it's really merchandise payables being well off for the right reasons, we didn't want to continue to restock on that. And so I think that's the reason the cash flow will reverse itself pretty aggressively on a positive basis with the inventory flow through, the return to refreshing inventory based on merchandised payables.

Jeff Stein - KeyBanc Capital Markets

Got it. So it sounds like working capital is a big chunk of it.

Rodney Carter

It's a big chunk of it.

Jeff Stein - KeyBanc Capital Markets

Okay. And then finally, with respect to the sale of extended warranties, just kind of back of the envelope math, it sound like with the five year amortization, it sounds to me like there's probably a 2 to 3-year period whereby we're not looking at apples-to-apples and it's going to have a negative impact on results year-over-year.

Rodney Carter

Well, continuing to sell it out, it'll be a negative impact for a number of years because you continue to layer in new ones.

Jeff Stein - KeyBanc Capital Markets

Right. But in terms of incremental year-over-year, it sounds to me like it's perhaps between year two and three that we should begin to see kind of a leveling out.

Rodney Carter

Yeah. After a couple of years, it will start leveling out. What you're going to see, and as you even see it on the balance sheet today, is you'll see a significant increase in deferred liabilities. Big jump. And what that is and so we'll have a lot of revenue. And one thing to keep in mind is as we incur expenses as incurred; every dollar of deferred revenue recognition is also deferred pretax profit. So the flow through once that starts reversing back out is very powerful.

Jeff Stein - KeyBanc Capital Markets

Right. Very good. Thank you.

Operator

Your next question comes from Marc Bettinger with Stanford Group.

Marc Bettinger - Stanford Financial Group

Good morning, everybody. How are you?

Betsy Burton

Good, thank you.

Marc Bettinger - Stanford Financial Group

Just wondering if you could access the competitive landscape as you see it right now?

Betsy Burton

Sure. We believe, based off of everything we hear from our vendors that other jewelry, specialty jewelry, retailers are experiencing similar trends to what we are. If anything, we're sort of in the, I call it top of the pack, you could call it better than the ones that are really struggling.

So I think that overall everything you read about retail, I think is true. I think the gas prices have hit the moderate customer the hardest.

We are seeing good trends in our upscale Bailey's. I think again it's really the moderate customer. You read, I think, the other issue is jewelry is certainly not something that's a necessity. So, when people are cutting back in terms of what they've got X amount of disposable income.

Clearly they are cutting back on jewelry as opposed to things such as apparel, which are more of a necessity. So again, we believe that we are experiencing pretty similar trends to our key competition.

Marc Bettinger - Stanford Financial Group

Okay. Do you believe it's too early to make any kind of call on the second quarter of next year in terms of being conservative, being optimistic?

Betsy Burton

We are cautious at this point. And I think building a conservative plan is probably a prudent way to proceed. I think as you go into summer; gas has a lot more visibility. And I think as soon as we know where gas is going to settle out, we'll probably be in a better position. But at this point we are cautious about our projections. However, if you look at the opportunities, we believe we've got substantial opportunity in Q2 on the gross margin front.

As you recall, we were very promotionally priced, very aggressively priced, on our brilliant buys at holiday. So we believe we have substantial room for improvement in terms of gross margin dollars, which should help flow through right to the bottom line.

Marc Bettinger - Stanford Financial Group

Okay. And the portfolio review, is this a review to see how you would change management of the brands or the potential spinning off or selling of the brands?

Betsy Burton

All of the above.

Marc Bettinger - Stanford Financial Group

Okay. And I guess two other fast questions. The $70 million in excess inventory, you say that's gone by the end of the year?

Betsy Burton

Not all of it will be gone -- of the $50 million to $70 million also includes clearing about another, call it $15 million of the $40 million reserved clearance. So there will still be some quote program goods in excess at the end of the fiscal year.

Marc Bettinger - Stanford Financial Group

Okay. So do you see having gross margin pressure due to having some of that?

Betsy Burton

No, again, the going forward program merchandise just means we're not buying it and we're in good in stock position and we'll just continue to run through it at normal pricing. So there's no margin pressure there and the clearance is clearly well reserved for and it is moving. It's just we want to be -- make sure that we aren't trading regular sales for clearance sales.

Marc Bettinger - Stanford Financial Group

Okay, great. And last question, I think you said that the Zales brand and Gordon's store negative mid single digit comps in the third quarter?

Betsy Burton

Correct.

Marc Bettinger - Stanford Financial Group

Okay. And Canada was positive high single digits?

Betsy Burton

Correct.

Marc Bettinger - Stanford Financial Group

All right. If I understand this correctly, the business model is such that Canada at some point that model is supposed to translate over to Zales brand and Gordon's. I wanted to know if there was some sort of update you could provide regarding that and given the potential and the results?

Betsy Burton

Sure. I think there are a lot of things we can learn from Canada, but also keep in mind, there are some substantial differences. Most importantly, the market share that they garner there for the competitive landscape is very different than it is here. So I don't believe that the margins will be as high as what they are in Canada.

However, having said that, we have a huge opportunity as we move along the curve of direct sourcing to improve our gross margin. As you recall, Canada was really the pioneer in terms of direct sourcing. And today, they sit at almost 20% of their sales are diamond direct sourced, which is more than double what the Zale brand is here both the Zale and the Gordon's brand are here. So I think in terms of some of the other learning's, though, in terms of merchandise assortments, how to planogram, the discipline, training, all of those should be transferable to the United States.

And we believe, though, that to really see the benefits of, especially some of the people programs, you're probably talking a couple of years before you can expect the discipline that we have in Canada. And I think if you were to visit the stores in Canada, which we just recently did as a Board, it is very impressive in terms of the people in particular. And as you know, it's a very important relationship in terms of the consumer. So I think having trained, knowledgeable, friendly, courteous, sales associates is really the key to differentiating ourselves from our competition.

Marc Bettinger - Stanford Financial Group

Okay, Betsy, Rodney. Good luck. Thank you very much.

Betsy Burton

Thank you.

Rodney Carter

Thank you.

Operator

And there are no further questions at this time.

Betsy Burton

Thank you operator. Thank you all for joining us.

Operator

Thank you for participating in today's Zale Corporation earnings conference call. This call will be available for replay beginning at 10 'O clock a.m. Eastern Standard Time today through 11:59 p.m. Eastern Standard Time on Tuesday, May 29th, 2007. The conference ID number for the replay is 8433301. The number to dial in for the replay is 706-645-9291. You may now disconnect.

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