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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended July 31, 2002

OR

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

For the transition period from _______________ to _______________

Commission file no. 1-04129

Zale Corporation

Registrant’s telephone number, including area code: (972) 580-4000

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:
None

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X]        No [   ]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]

     As of September 17, 2002 the aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant was approximately $1,065,865,438.

     As of September 17, 2002, the registrant had outstanding 33,177,862 shares of its common stock, $.01 par value per share.

DOCUMENTS INCORPORATED BY REFERENCE.

     Part III of this report incorporates information from the registrant’s definitive Proxy Statement relating to the registrant’s annual meeting of stockholders to be held on November 1, 2002.

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PART I

General

     Zale Corporation, along with its wholly owned subsidiaries (the “Company”) is the largest specialty retailer of fine jewelry in North America. At July 31, 2002, the Company operated 2,295 specialty retail jewelry stores and kiosks located primarily in shopping malls throughout the United States, Canada and Puerto Rico. The Company principally operates under six brands, each targeted to reach a distinct customer. Zales Jewelers® is the Company’s national brand which provides traditional, moderately priced jewelry to a broad range of customers. Zales Jewelers has extended the reach of its brand to Zales the Diamond Store Outlet® and Zales.com. Zales the Diamond Store Outlet® focuses on the brand conscious, value oriented shopper, offering jewelry at discounts off everyday retail prices in outlet centers. Peoples Jewellers®, the Company’s national brand in Canada, offers traditional moderately priced jewelry to customers throughout Canada. Gordon’s Jewelers® in the United States, and Mappins Jewelers® in Canada, offer contemporary jewelry merchandise designed to attract slightly higher purchases. Bailey Banks & Biddle Fine Jewelers® operates upscale jewelry stores that are considered among the finest jewelry stores in their markets, offering designer merchandise such as Cartier to more affluent customers. Piercing Pagoda® reaches the opening price point jewelry customer primarily through mall based kiosks. During the fiscal year ended July 31, 2002 (“fiscal year 2002”), the Company generated $2.2 billion of net revenues.

     The Company believes it is well-positioned to compete in the approximately $40 billion, highly fragmented retail jewelry industry, leveraging its established brand names, economies of scale and geographic and demographic diversity. The Company enjoys significant brand name recognition as a result of its long-standing presence in the industry and its national and regional advertising campaigns. The Company believes that brand name recognition is an important advantage in jewelry retailing as products are generally unbranded and consumers must trust in a retailer’s reliability, credibility and commitment to customer service. The Company believes that consumers rely on known brand names to ensure quality. This assurance is especially important when consumers feel they lack the expertise to evaluate quality and value of jewelry purchases. In addition, as the largest specialty retailer of fine jewelry in North America, the Company believes it realizes economies of scale in purchasing, distribution, real estate, advertising and administrative costs. The Company also believes that the geographic diversity of its retail distribution network through all 50 states, Puerto Rico and Canada, and the demographic breadth of its target customer groups may serve to reduce earnings volatility typically associated with local or regional conditions.

     The Company is incorporated in Delaware. Its principal executive offices are located at 901 W. Walnut Hill Lane, Irving, Texas 75038-1003. Its telephone number at that address is (972) 580-4000, and its internet address is www.zalecorp.com.

Business Initiatives and Strategy

     Fiscal year 2002 continued to be a rebuilding year for the Company, made even more challenging with the volatility of the external economic environment. The Company continued the merchandising discipline and cost control programs that were renewed in the second half of fiscal year 2001. Tighter controls were implemented and management closely evaluates the return on investment of all cost decisions. Thus, management believes inventory and expense structures are now consistent with projected revenue growth and market conditions. In fiscal year 2002, management focused on strengthening the core bridal and solitaire business. This business was repositioned with higher quality merchandise throughout the brands, supported with marketing dollars, an enhanced credit offering and store level training. Management believes these efforts have raised the average check.

     The Company relies on its merchandising and marketing strategies to differentiate its brands to consumers. Management has developed a key item strategy as the foundation for merchandising and marketing initiatives. Key items are selected from among the best selling products in the retail jewelry industry. The Company advertises these items heavily and works to ensure these items are available to customers at all times. In fiscal year 2002, the Company strengthened the key item approach by brand, expanding the featured “Brilliant Buy” concept across all brands. These items, that the Company believes are an exceptional value to the customer, are identified and displayed prominently throughout the store along with their prices.

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     While maintaining the Company’s traditional key item approach, overall inventory management has been enhanced this year. The Company’s goal is to execute an aggressive approach to inventory management by keeping key items in stock and purchasing to a rate of sale. In late fiscal year 2001, inventory assortments were reevaluated and adjusted by brand, especially in top performing stores. Product assortments capitalize on year round gift giving, fashion and special occasions, while the focus continues to remain on the bridal category. Inventory management improvements have allowed the Company to narrow and deepen product assortment by brand. The Company believes that an element of brand integrity is to maintain an in-stock position. The current forecasting process will be enhanced by the implementation of a store level forecasting system implemented throughout fiscal year 2003.

     The Company has a buyer training program to develop and train new buyers on merchandise and Company standards. The Company also has a centralized purchasing process for each brand to ensure consistency of quality and cost. In addition, the Company leverages its size to achieve better prices, payment terms, return privileges and cooperative advertising arrangements with product suppliers.

     As the industry leader, the Company capitalizes on jewelry trends, such as demand for solitaires, three-stone jewelry, white metals, and princess cut fashion jewelry. This year, solitaires helped to continue to build the bridal area. The “proprietary diamond” concept was expanded across all brands, except for Piercing Pagoda. Each concept has its own branded signature diamond, such as the Zales Diamond, Gordon’s Diamond, and Peoples Diamond. The proprietary diamond concept expanded this year to include the Zales diamond anniversary band, the Zales three-stone ring, and in the first quarter of fiscal year 2003, the Zales three stone pendant was introduced.

     The Company’s marketing efforts are designed to enhance brand identity through distinctive brand communication to the customers. The Company has created highly visible marketing programs specifically targeted in television, newspaper inserts, radio and magazines. Most of these programs are product and event-focused, usually highlighting key items as well as capitalizing on jewelry trends, such as solitaires, three-stone jewelry and princess cut fashion jewelry. The Company maintains a balance in advertising between media and targeted direct mail. While the Company believes it dominates jewelry advertising on television during the Christmas season, marketing efforts extend beyond the Holiday season to tie in with other gift-giving holidays, such as Valentine’s Day and Mother’s Day. In addition, advertising and in-store promotions are synchronized with mall marketing efforts to take advantage of other periods of high mall traffic, such as Labor Day, which are typically not considered jewelry-oriented holidays.

     In fiscal year 2002, the Company allocated advertising dollars towards creating a more competitive credit offering. Management attributes part of its success in raising the average check and strengthening the bridal business to this twelve-month interest free credit offering. With the successful transition of outsourcing the credit business, the Company can now offer more competitive credit programs by brand.

     The marketing strategy evolved in fiscal year 2002 to provide a fresh advertising look for every brand. The elevated importance of relationships this past year has been a key to the success of three stone jewelry with the “Past, Present, Future” message. Management believes that the recently acquired Piercing Pagoda brand’s marketing strategy holds further development opportunities. Additionally, the Company currently has an extensive database of customer names available to direct promotional material to in its target marketing programs.

     The Company’s goals for fiscal year 2003 remain consistent. Management plans to maintain a conservative new store growth plan, with a focus on increasing existing store productivity and profitability. The Company plans to improve the all-important bridal business, while maintaining a balance between bridal/solitaire and fashion jewelry sales. Further differentiation of the brands remains a top priority. The Company will continue to leverage the integrity of the brands by enhancing the proprietary diamond collections.

     Piercing Pagoda is a key component of the Company’s future growth. Management plans to leverage Piercing Pagoda’s size, corporate structure and brand credibility, with a renewed focus on ear piercing, and a more regional, updated merchandise assortment.

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     The Company plans to open approximately 60 new locations, principally under the brand names Zales, Zales Outlet, and Piercing Pagoda for which it expects to incur approximately $10 million in capital expenditures during the fiscal year 2003. The Company is seeking strategic locations where it is underrepresented to solidify the Company’s core mall business, and expand into new outlet centers. The Company targets premier regional mall locations throughout the country and selects sites based on a variety of well-defined demographic and store profitability characteristics. The Company has identified the specific malls for this planned expansion in fiscal year 2003 that satisfy the Company’s real estate strategy. The Company also plans to refurbish, remodel or relocate approximately 226 stores and kiosks at a cost of approximately $33 million during fiscal year 2003.

     In fiscal year 2003, the Company will stay focused on an effort to reduce selling, general and administrative expenses by streamlining processes and leveraging technology where possible. Initiatives include: improvement of current processes and application of new technology in areas such as merchandising, distribution and financial systems; and managing advertising expense for a better return on investment.

Current Year Events

     Retiree Medical Plan Curtailment. In January 2002, the Company amended its Retiree Medical Plan to limit retiree health coverage to only those retirees who were already participants in the Plan and to those otherwise eligible employees who elected to retire prior to April 1, 2002. Retiree health benefits will no longer be available to those current employees who were previously in the eligible class of employees (i.e., those hired prior to November 15, 1994, if they retired at age 55 or older with ten or more years of continuous service). In January 2002, the Company recorded a $3.5 million gain related to this curtailment of its Retiree Medical Plan.

     Retirement of Chairman of the Board and Chief Executive Officer. In March 2002, Robert J. DiNicola announced his retirement as Chief Executive Officer and Chairman of the Board of Directors, effective at the end of fiscal year 2002. Mr. DiNicola will remain as Chairman of the Board in a non-executive capacity and has entered into a consulting agreement with the Company. Effective August 1, 2002, Mary L. Forté, who served as Executive Vice President and Chief Merchandise Officer, was appointed to serve as President and Chief Executive Officer and was named a member of the Company’s Board of Directors.

     Repurchase of Senior Notes. In the fourth quarter of fiscal year 2002, the Company repurchased on the open market and cancelled $13 million of Senior Notes. The Company recognized an $0.8 million loss related to this extinguishment of debt. This loss is reported in net interest expense on the Statement of Operations.

     Change in Certifying Accountant. In June 2002, the Company announced that the Board of Directors upon recommendation from its Audit Committee, ended the engagement of Arthur Andersen LLP as the Company’s independent public accountants, and engaged KPMG LLP to serve as the Company’s independent public accountants for the fiscal year ending July 31, 2002.

     Stock Repurchase Plan. On July 17, 2002, the Company announced that its Board of Directors had approved a stock repurchase program under which the Company, from time to time and at management’s discretion and in accordance with the Company’s usual policies and applicable securities laws, may purchase, up to an aggregate of $50 million of Zale common stock on the open market through July 31, 2003. Under this program, the Company purchased 0.2 million shares at an aggregate cost of $4.4 million through July 31, 2002. In July 2002, the Company completed its fiscal year 2002 stock repurchase program, which was authorized in August 2001. Under this $50 million program, the Company repurchased 1.3 million shares at an aggregate cost of $50 million in fiscal year 2002.

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Industry

     The U.S. retail jewelry industry’s sales were approximately $40 billion in 2001. Specialty jewelry stores (such as the Company) account for over half of the industry, according to publicly available data. Historically, retail jewelry store sales have exhibited only limited effects of cyclicality. The United States Census Bureau has recorded only two years of negative growth in specialty retail jewelry store sales from 1984 to 2001. Other significant segments of the 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 composed primarily of catalog and mail order houses, direct-selling establishments, TV home shopping (such as QVC, Inc.) and computer on-line shopping.

     The U.S. retail jewelry industry is highly fragmented with the seven largest companies accounting for less than 25 percent of the market. The largest jewelry retailer is believed to be Wal-Mart Stores, Inc., followed by the Company. The Company is the largest specialty jewelry retail chain in North America, with approximately eight percent of the specialty jewelry market share, based on estimates from the United States Census Bureau. Only two other specialty jewelry retailers had greater than two percent market share.

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Operations

     The Company operates principally under six brands. The following table presents total revenues, average sales per location and the number of locations for Zales, Zales the Diamond Store Outlet (Zales Outlet), Gordon’s, Bailey Banks & Biddle, Peoples (including Mappins stores), and Piercing Pagoda for the periods indicated.

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Zales Jewelers

     Zales, the Company’s national flagship and the nation’s largest specialty jeweler, is a leading brand name in jewelry retailing in the United States. At July 31, 2002, Zales had 757 stores in 50 states and Puerto Rico. Zales average store size is 1,568 square feet, and the average selling price per unit sold is $277. The Zales brand accounted for 46 percent of the Company’s total revenues in fiscal year 2002.

     Zales’ merchandise selection is generally standardized across the nation and targeted at customers representing a cross-section of mainstream America. In fiscal year 2002, bridal merchandise represented 37 percent of merchandise sales, while fashion jewelry and watches comprised the remaining 63 percent. The bridal merchandise category consists of engagement rings, bridal sets and diamond anniversary bands. Fashion jewelry consists generally of diamond fashion rings, certain semi-precious stones, earrings, gold chains, watches and various other items. The Company believes that the prominence of diamond jewelry in its product selection and its reputation for customer service for over 78 years fosters an image of quality and trust among consumers. While placing added emphasis on the bridal segment of the business, Zales maintains a balance with non-bridal merchandise such as fashion jewelry and watches to drive gift giving occasions throughout the year.

     Zales also introduces innovative items and capitalizes on industry trends, including platinum engagement rings, white gold, princess cut fashion jewelry and three stone jewelry. In 2001, Zales introduced the Company’s first proprietary diamond, the “Zales Diamond.” The Zales diamond is a unique, 8 sided, patented cut diamond with 82 facets for extraordinary brilliance. The exclusive “Zales” branded merchandise line was expanded to include the “Zales anniversary band” and the “Zales three stone ring,” now available in two different carat sizes in a platinum setting. The Zales three stone pendant was introduced in August 2002. Featured “Brilliant Buys” continue to maintain prominent positioning in Zales’ merchandise presentation and marketing media.

     The combination of Zales’ national presence and centralized merchandise selection allows it to use television advertising across the nation as its primary advertising medium, supplemented by newspaper inserts and direct mail. Zales continues to support its brand awareness through its sponsorship of the Rockefeller Center Christmas Tree Lighting. Zales serves its Internet customer through its web site Zales.com, which accounted for less than one percent of the Company’s total revenues in fiscal year 2002.

Zales the Diamond Store Outlet

     At July 31, 2002, the Company operated 92 Zales Outlet stores in 33 states and Puerto Rico, including 10 stores opened in fiscal year 2002. The average store size is 2,249 square feet, and the average selling price per unit sold is $280. Zales Outlet accounted for five percent of the Company’s total revenues in fiscal year 2002. Zales the Diamond Store Outlet benefits from Zales’ brand recognition and national advertising programs.

     The outlet concept has evolved to be one of the strongest new concepts in retail shopping today, featuring top brands in every major retail category. The Company has grown its Zales Outlet concept during the past four years and plans to continue its growth over the next several years. The merchandise assortment in a Zales Outlet store caters to the brand conscious and value-oriented female shopper, offering 20-70 percent off traditional retail prices everyday.

     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 product line and promotional efforts are geared specifically to the outlet consumer who is both value and name brand driven. In addition to fashion forward looks in diamonds, gemstones, gold and name brand watches, Zales Outlet has been successful with certified and exclusive products. The “Lilla Diamond”, a diamond exclusive to Zales Outlet is a 98 faceted diamond set in platinum accompanied with a certification. Also, the Zales Outlet’s special collection of “Exceptional Values” offers good value on best selling items in each merchandise category.

Gordon’s Jewelers

     Gordon’s is positioned as the Company’s major regional brand. As of July 31, 2002, Gordon’s had 298 stores in 34 states and Puerto Rico. Average store size is 1,436 square feet and the average selling price per unit sold is $362. Gordon’s accounted for 15 percent of the Company’s total revenues in fiscal year 2002.

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     The Company is continuing steps to differentiate Gordon’s image, including store remodeling and improved merchandise and marketing, with a focus on exclusive and certified diamond merchandise.

     Gordon’s distinguishes itself from Zales by providing a more upscale, contemporary product mix and tailoring a portion of the store inventory to regional tastes. Gordon’s has selections for both the entry price point customer as well as the more discerning, established jewelry customer. Gordon’s offers a broad range of merchandise, such as diamond solitaires, bold gold, jewelry set in platinum and semi-precious gems. Gordon’s introduced the “Gordon’s Diamond,” which is exclusive to Gordon’s in August 2002. This diamond has 73 facets uniquely arranged to create a sunburst effect. Gordon’s will expand “The Gordon’s Diamond” into other categories beyond bridal in fiscal year 2003.

     Gordon’s utilizes an advertising media mix consisting primarily of radio, newspaper advertising, and direct mail. As the Gordon’s customer database continues to grow, direct mail is expected to become a greater part of the mix.

Bailey Banks & Biddle Fine Jewelers

     Established in 1832, Bailey Banks & Biddle offers high-end merchandise, exclusive designs and a prestigious shopping environment for the upscale customer. The stores are among the pre-eminent stores in their markets and carry both exclusive and recognized branded and designer merchandise selections to appeal to the more affluent customer, while maintaining a fine jewelry selection for the mall based customer. These brands and designers include Cartier, Baume & Mercier, Mikimoto, Roberto Coin and David Yurman. The Bailey Banks & Biddle merchandise assortments emphasize the classic and traditional look and focus on diamonds, precious stones and gold jewelry, as well as watches and giftware. In fiscal year 2002, Bailey Banks & Biddle introduced the exclusive Linz Diamond. Available exclusively at Bailey Banks & Biddle, the Linz Diamond is a uniquely shaped diamond with 69 facets.

     At July 31, 2002, Bailey Banks & Biddle operated 120 upscale jewelry stores in 31 states and Puerto Rico. The Company also utilizes the trade name Zell Bros.® for one of its stores. The stores have an average selling price per unit sold of $854, have an average store size of 3,589 square feet and accounted for 14 percent of the Company’s total revenues in fiscal year 2002.

     Bailey Banks & Biddle stores rely heavily on upscale direct-mail catalogs, enabling the stores to focus on specific products for specific customers. In fiscal year 2002, Bailey Banks & Biddle continued to expand its advertising reach with a repetitive presence in nationally distributed newspapers such as The New York Times and The Wall Street Journal and high profile magazines such as Town & Country, Architectural Digest, House and Garden, In Style, Vogue, W, and Bon Appetit.

     In fiscal year 2003, Bailey Banks & Biddle will utilize targeted direct mail, home and lifestyle magazines, as well as fashion magazines to increase its customer base. Bailey Banks & Biddle also plans to expand its merchandise assortments with additional prestige brand watch lines while it will upgrade diamond quality. Bailey Banks & Biddle plans to focus on inventory selections within each merchandise category, creating the proper breadth of assortment. Additionally, it plans on enhancing the visual impact of its stores in the coming year.

Peoples Jewellers

     In May 1999, Zale Corporation acquired the Peoples Jewellers Corporation, a privately owned chain of jewelry retail outlets in Canada, operating under the banners of Peoples Jewellers and Mappins Jewellers. This operation now has 171 stores in nine provinces across Canada and enjoys the largest market share of any jewelry retailer in Canada. The stores have an average selling price per unit of $131, an average store size of 1,571 square feet and accounted for seven percent of the Company’s total revenues in fiscal year 2002.

     The primary banner, Peoples Jewellers, is one of the most recognized brand names in Canada. Peoples offers traditional jewelry at affordable prices, attracting a wide variety of Canadian customers. Peoples is targeted at customers between the ages of 25-59, with a focus on the consumer in the mall environment. Using the trademark “Peoples, the Diamond Store” in Canada, Peoples emphasizes its diamond business, while also offering a wide selection of other traditional jewelry and watch products.

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     Since 2000, the Peoples brand has been building recognition using television and newspaper inserts. Over the past three years, Peoples had the largest television campaign of any Canadian jewelry retailer by a wide margin. Seasonal newspaper insertions assisted the growth of the business in these years. Peoples will add limited mailings of focused key catalogues in the diamond and watch categories to expand this media mix in fiscal year 2003.

     In 2001, Peoples successfully launched a 128 facet brilliant cut diamond as the “Peoples Diamond”. With the growth of this solitaire product, a three-stone ring, anniversary band and other line extensions were launched successfully. In fiscal year 2003, the “Peoples Diamond” concept will expand to include a Peoples exclusive “Canadian Diamond Collection” mined, cut and polished in Canada. This unique Canadian offering will enhance the already expanded and successful bridal and anniversary categories in the Peoples chain.

     Mappins Jewellers continues to be a strong second brand in Canada. Building on a history from 1936, Mappins is recognized as a regional jeweler in key mall locations. The Mappins consumer selects from classic fashion styles at moderate prices. Since 2000, Mappins has had the benefit of focused newspaper inserts and targeted direct mail offers.

Piercing Pagoda

     Effective September 20, 2000, the Company acquired Piercing Pagoda, Inc., the largest retailer of gold jewelry principally through kiosk locations in the United States. At July 31, 2002, Piercing Pagoda operated 857 locations in 44 states and Puerto Rico, under the names Piercing Pagoda, Plum Gold, Silver and Gold Connection and Diamond Isle. Piercing Pagoda represented 12 percent of total revenues in fiscal year 2002. Piercing Pagoda offers an extensive collection of popularly priced 14 karat and 10 karat gold chains, bracelets, earrings, charms and rings, as well as a selection of silver and diamond jewelry, all basic styles at everyday low prices. In addition, ear piercing services are performed by trained associates on site. The Piercing Pagoda locations are generally located in high traffic concourses of regional shopping malls.

     The kiosk locations average 188 square feet in size and are easily accessible and visible within malls. In fiscal year 2002, the average price per unit was $25. The kiosks focus on the opening price point customer.

     In fiscal year 2003, there will be renewed focus on ear-piercing, and a more regional, updated merchandise assortment to drive traffic and brand equity. The Company plans to market Piercing Pagoda as the authority in ear piercing. Additionally, an updated kiosk design is expected to improve productivity and allow for greater merchandise capacity.

Insurance Affiliates

     The Company, through Zale Indemnity Company, Zale Life Insurance Company and Jewel Re-Insurance Ltd., provides insurance and reinsurance facilities for various types of insurance coverage, which typically are marketed to the Company’s private label credit card customers. In fiscal year 2002, over 41 percent of the Company’s private label credit card purchasers purchased some form of credit insurance. The three companies are the insurers (either through direct written or reinsurance contracts) of the Company’s customer credit insurance coverages. In addition to providing replacement property coverage for certain perils, such as theft, 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 eligible employees of the Company. Zale Indemnity Company, in addition to writing direct credit insurance contracts, also has certain discontinued business that it continues to run off. Credit insurance operations are dependent on the Company’s retail sales on its private label credit cards. Under the current private label arrangement with Citi Commerce Solutions, the Company’s insurance affiliates continue to provide insurance to holders of the Company’s private label credit cards and receive payments for such insurance products. Insurance premium revenues of $18.3 million, $19.0 million, and $19.7 million for fiscal years ended July 31, 2002, 2001 and 2000, respectively are included in total revenues.

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Store Operations

     The Company’s stores are designed to create an attractive environment, to make shopping convenient and enjoyable, and to maximize operating efficiencies. The Company pays careful attention to store layout, particularly in areas such as lighting, choice of materials and arrangement of display cases to maximize merchandise presentation. Promotional displays are changed periodically to provide variety or to reflect seasonal events.

     Each of the Company’s stores is led by a store manager who is responsible for certain store-level operations, including sales and certain personnel matters. Non-sales administrative matters, including purchasing, credit operations and payroll are consolidated at the corporate level in an effort to maintain low operating costs at the store level. Each store also offers standard warranties and return policies and provides extended warranty coverage that may be purchased at the customer’s option.

     The Company has implemented inventory control systems, extensive security systems and loss prevention procedures to maintain low inventory losses. The Company screens employment applicants and provides its store personnel with training in loss prevention. Despite such precautions, the Company experiences losses from theft from time to time and maintains insurance to cover such external losses.

     The Company believes it is important to provide knowledgeable and responsive customer service. There continues to be a strong focus on connecting with the customer, both through advertising and once the customer is in the store. The goal is to service the customer from the first sale to maintaining a customer connection through client services. The Company recently consolidated previously fragmented customer service departments into a single customer service call center to more effectively address customer phone calls. The Company has employee training programs, including training in sales techniques for new employees, on-the-job training and management training for store managers. Under the banner of Zale Corporation University, the Company offers training to employees at every level of the organization, from sales associate to buyer.

Purchasing and Inventory

     The Company purchases substantially all of its 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 the corporate headquarters. The Company either purchases merchandise from its vendors or obtains merchandise on consignment. Consignment inventory historically consists 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 at any time. The Company had approximately $162.2 million and $186.2 million of consignment inventory on hand at July 31, 2002 and 2001, respectively. During fiscal years 2002 and 2001, the Company purchased approximately 34 percent and 35 percent, respectively, of its merchandise from its top five vendors, including more than 12 percent from its top vendor.

     The Company historically has not engaged in any substantial amount of hedging activities with respect to merchandise held in inventory, as commodity prices have remained relatively stable. The Company is not subject to substantial currency fluctuations because most purchases are U.S. dollar denominated. The Company continually reviews its position on hedging and will take steps to hedge certain commodity components or currency positions if appropriate. The Company has entered into forward exchange hedge contracts to minimize the market risk from currency exchange rate exposure.

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Proprietary Credit

     The Company’s 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 sources. Approximately 44 percent and 40 percent of the Company’s net sales from operations excluding Piercing Pagoda, which does not offer proprietary credit, were generated by credit sales on these credit cards in fiscal year 2002 and 2001, respectively. In fiscal year 2002, the Company expanded its offer of its twelve-month interest free credit plan to its customers to encompass non-holiday periods that, coupled with improved merchandise assortments, increased the bridal business and the average price per unit sold. The Company has found that by offering its customers a credit account, its sales personnel are able to build customer relationships that generate loyalty and facilitate repeat purchases, while at the same time enhancing the Company’s target marketing capability. In July 2000, the Company sold all of its domestic proprietary credit accounts receivable to Associates (now a part of Citi Commerce Solutions). In connection with this sale, the Company entered into a ten-year agreement whereby Citi Commerce Solutions will issue private label credit cards branded with appropriate Company trademarks, and provide financing for the Company’s customers to purchase merchandise in exchange for payment by the Company of a merchant fee based on a percentage of each credit card sale. The merchant fee is a percentage per credit sale credited to the Company for standard revolving accounts and a percent per credit sale charged to the Company under certain promotional credit programs. In fiscal year 2001, the Company converted its Canadian private label credit agreement to Citi Commerce Solutions Canada.

Employees

     As of July 31, 2002, the Company had approximately 19,000 employees, less than 10 percent which were Canadian employees, and less than one percent of whom were represented by unions. The Company usually hires a limited number of temporary employees during each Holiday season.

Competition

     The retailing industry is highly competitive. The industry is fragmented, and the Company competes with a large number of independent regional and local jewelry retailers, as well as national jewelry chains. The Company also competes with other types of retailers who sell jewelry and gift items, such as department stores, catalog showrooms, discounters, direct mail suppliers, online retailers and television home shopping programs. Certain of the Company’s competitors are non-specialty retailers which are larger and have greater financial resources than the Company. The malls where the Company’s stores are located typically contain competing national chains, independent jewelry stores or department store jewelry departments. The Company believes that it is also competing for consumers’ discretionary spending dollars and, therefore, competes with retailers who offer merchandise other than jewelry or giftware.

     Notwithstanding the national or regional reputation of its competition, the Company believes that it must compete on a mall-by-mall basis with other retailers of jewelry as well as with retailers of other types of discretionary items. Therefore, the Company competes primarily on the basis of reputation for high quality products, brand recognition, store location, distinctive and value-priced merchandise, personalized customer service and its ability to offer private label credit card programs to customers wishing to finance their purchases. The Company’s success is also dependent on its ability to react to and create customer demand for specific merchandise categories.

     The Company holds no material patents, licenses, franchises or concessions; however, the established trademarks and trade names of the Company are essential to maintaining its competitive position in the jewelry retailing industry.

Seasonality

     As a specialty retailer of fine jewelry, the Company’s business is seasonal in nature, with its second quarter, which includes the months of November through January, typically representing a proportionally greater percentage of annual sales, earnings from operations and cash flow. Management expects such seasonality to continue.

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Management Information Systems

     The Company’s information systems provide information necessary for: (i) management operating decisions; (ii) sales and margin management; (iii) inventory control; (iv) profitability monitoring by many measures (merchandise category, buyer, store); and (v) expense control programs. 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 timely sales and margin data compilation and to provide for inventory control monitoring. Information is made available on-line to merchandising staff on a timely basis, thereby reducing the need for paper reports. Future initiatives include making store level sales and inventory forecasting tools available to the buyers and improved connectivity between stores and the home office to enhance operating efficiencies.

     The Company’s information systems allow management to monitor, review and control operational performance on a daily, monthly, quarterly and annual basis for each store and transaction. Senior management can therefore review and analyze activity by store, amount of sale, terms of sale or employees who sell the merchandise.

     The Company has an operations services agreement with a third party for the management of the Company’s mainframe processing operations, client server systems, Local Area Network operations, Wide Area Network management, e-business hosting and desktop support. The agreement, which was effective August 1, 2002, requires fixed payments totaling $11 million over a 36 month term and a variable amount based on usage. The Company has an option to extend the current agreement for two consecutive one year periods. The payments under this contract reflect an annual cost savings of over $3 million due to investments in certain infrastructure over the past several years. The Company believes that by outsourcing this portion of its management information systems it achieves additional efficiencies and allows the Company to focus its internal information technology efforts on developing and enhancing enterprise systems for its core business.

     The Company has historically upgraded, and expects to continue to upgrade, its information systems to improve operations and support future growth. The Company estimates it will make capital expenditures of approximately $9 million in fiscal year 2003 for enhancements to its information systems and infrastructure.

Regulation

     The Company’s 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 the Company’s private label credit cards, credit to the Company’s 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 the Company’s traditional customer base could adversely affect the Company’s results of operations or financial condition.

     The Company is 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 the Company is also highly regulated. State laws currently impose disclosure obligations with respect to the Company’s sale of credit and other insurance. In addition, the Company’s sale of insurance products in connection with its private label credit cards appears to be subject to certain disclosure and other requirements under the Gramm-Leach-Bliley Act of 1999. The Company’s and its competitors’ practices are also subject to review in the ordinary course of business by the Federal Trade Commission and the Company’s and other retail companies’ credit cards are subject to regulation by the Office of the Comptroller of the Currency. See “Business Credit Operations.” The Company believes that it is currently in material compliance with all applicable state and federal regulations.

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     Merchandise in the retail jewelry industry is frequently sold at a discount off the “regular” or “original” price. A number of jurisdictions in which the Company operates have regulations that require that retailers offering merchandise at discounted prices must offer the merchandise at regular or original prices for stated periods of time. Additionally, the Company is subject to certain truth-in-advertising and other various laws, including consumer protection regulations that regulate retailers generally and/or the promotion and sale of jewelry in particular. The Company undertakes to monitor changes in those laws and believes that it is in material compliance with applicable laws with respect to such practices.

Cautionary Notice Regarding Forward-Looking Statements

     This Annual Report on Form 10-K contains forward-looking statements, including statements regarding the Company’s objectives and expectations regarding its sales and earnings, merchandising and marketing strategies, store renovation, remodeling and expansion, inventory management and performance, liquidity, cash flows, capital expenditures and development of its management information systems and e-commerce sites, which are based upon management’s beliefs as well as on assumptions made by and data currently available to management. In addition, the words “anticipate,” “estimate,” “project,” “intend,” “expect,” “believe,” “forecast,” and similar expressions may identify forward looking statements, but some of these statements may uses other phrasing. These forward-looking statements are not guarantees of future performance and a variety of factors could cause the Company’s actual results to differ materially from the anticipated or expected results expressed in or suggested by these forward-looking statements. The following list, which is not intended to be an all encompassing list of risks and uncertainties affecting the Company, summarizes several factors that could cause the Company’s actual results to differ from those anticipated or expected in these forward-looking statements: that low or negative growth in the economy or in the financial markets will occur and reduce discretionary spending on goods that are, or are perceived to be “luxuries”; that warehousing and distribution productivity and capacity can be further improved to support the Company’s distribution requirements; that strong competitive responses may impact the Company’s efforts to leverage its brand power with its marketing, merchandising and promotional efforts; that seasonality of the retail jewelry business or downturns in consumer spending during the fourth calendar quarter may adversely affect the Company’s results; that the Company may not be able to continue to manage its inventory and product supply effectively to respond to consumer demand; that fluctuations in diamond prices may negatively affect the business; that the Company may not be able to integrate acquisitions into its existing operations or that new acquisition and alliance opportunities that enhance shareholder value may not be available on terms acceptable to the Company; that the efforts to redefine the strategic role of each brand may not be successful; that legal or governmental proceedings may have an adverse effect on the financial results or reputation of the Company; that alternate sources of merchandise supply may not be available on favorable terms to the Company during the three month period leading up to the Christmas season; that key personnel who have been hired or retained by the Company may depart; that any disruption in or changes to the Company’s private label credit card arrangement with Citi Commerce Solutions may adversely affect the Company’s ability to provide consumer credit; or that changes in government or regulatory requirements may increase the cost of or adversely affect the Company’s operations. The Company disclaims any obligation to update or revise publicly or otherwise any forward-looking statements to reflect subsequent events, new information or future circumstances.

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     The Company leases a 430,000 square foot corporate headquarters facility, which extends through 2008. The facility is located in Las Colinas, a planned business development in Irving, Texas, near the Dallas/Fort Worth International Airport. During fiscal year 1999, the Company sold a 120,000 square foot warehouse in Dallas, Texas, leasing back approximately 60,000 square feet of that warehouse. The Company also owns a 73,000 square foot building in Bethlehem, Pennsylvania that serves as Piercing Pagoda’s distribution center. Another 71,000 square foot building owned by the Company is located adjacent to the Bethlehem property is used for additional distribution and warehousing functions. The Company leases a 7,400 square foot distribution and warehousing facility in Toronto, Ontario, Canada for Peoples, which lease extends to October 2003.

     The Company rents most of its store retail space under leases that generally range from five to ten years and may contain minimum rent escalations, while kiosk leases generally range from three to five years. Most of the store leases provide for the payment of base rentals plus real estate taxes, insurance, common area maintenance fees and merchants association dues, as well as percentage rents based on the stores’ gross sales.

     The following table indicates the expiration dates of the current terms of the Company’s leases as of July 31, 2002:

     Management believes substantially all of the store leases expiring in fiscal year 2003 that it wishes to renew (including leases which expired earlier and are on month-to-month extensions) will be renewed on terms not materially less favorable to the Company than the terms of the expiring leases. Management believes its facilities are suitable and adequate for the Company’s business as presently conducted.

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     The Company is involved in certain legal actions and claims arising in the ordinary course of business. The Company currently believes that such litigation and claims, both individually and in the aggregate, will be resolved without material effect on the Company’s financial position or results of operations. However, litigation involves an element of uncertainty. Future developments could result in significant changes in litigation reserves.

     On November 3, 1999, a plaintiff amended a complaint filed in the Circuit Court for Colbert County, State of Alabama to commence a purported class action against the Company, Jewelers National Bank, Zale Indemnity Company, Zale Life Insurance Company, Jewelers Financial Services, Jewel Re-Insurance, Ltd. and certain employees of the Company. On July 21, 2000, the same plaintiff commenced a purported class action in the United States District Court for the Eastern District of Texas, Texarkana Division against the Company, Jewelers National Bank, Zale Indemnity Company, Zale Life Insurance Company, Jewel Re-Insurance, Ltd. and certain employees of the Company. Both purported class actions concern allegations that the defendants marketed credit insurance to customers in violation of state statutory and common laws and bring claims based on, inter alia, fraud, breach of contract and consumer protection laws. The federal complaint alleges that the Company’s credit insurance practices violated federal anti-racketeering laws. In both complaints, the plaintiff seeks, among other things, compensatory and punitive damages as well as injunctive relief. Both actions are in the discovery stage, and neither has been certified as a class action. Although the Company is vigorously defending the alleged claims, settlement negotiations are ongoing.

     On October 23, 2001 a plaintiff filed a complaint against Zale Corporation and Zale Delaware, Inc. in the Superior Court of California, County of Los Angeles, Central District. The complaint is a purported class action on behalf of current and former salaried store managers and assistant store managers of the Company in California. The complaint alleges that these individuals were entitled to overtime pay and should not have been classified as exempt employees under California law. Plaintiff seeks recovery of overtime pay, declaratory relief and attorneys’ fees. This action is in the discovery stage and has not been certified as a class action. The Company intends to vigorously defend the action.

     The Company has established reserves based on the current status of each case. Certification of the matters as class actions could result in adjustments to the reserves.

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     No matters were submitted to a vote of security holders of the Company during the quarter ended July 31, 2002.

EXECUTIVE OFFICERS AND KEY EMPLOYEES OF THE REGISTRANT

     The following individuals serve as executive officers of the Company. Officers are elected by the Board of Directors annually, each to serve until their successor is elected and qualified, or until their earlier resignation, removal from office or death.

Executive Officers

     The following is a brief description of the business experience of the executive officers of the Company for at least the past five years.

     Ms. Mary L. Forté was named President and Chief Executive Officer and appointed to the Company’s Board of Directors, effective August 1, 2002. Prior to that appointment, Ms. Forté served as Executive Vice President and Chief Merchandise Officer from February 2001 to July 2002. From January 1998 to February 2001, she served as Executive Vice President and Chief Administrative Officer. Ms. Forté joined the Company in July 1994 as the President of Gordon’s, and served in that position until January 1998. From January 1994 to July 1994, Ms. Forté served as Senior Vice President of QVC — Home Shopping Network. From July 1991 through January 1994, Ms. Forté served as Senior Vice President of the Bon Marché, Home Division of the Federated Department Store. From July 1989 to July 1991, Ms. Forté was Vice President of Rich’s Department Store, Housewares Division. In addition to the above, Ms. Forté has an additional 13 years of retailing and merchandising experience with Macy’s, The May Department Stores Company, Inc. and Federated Department Stores.

     Ms. Sue E. Gove was appointed Chief Operating Officer effective August 1, 2002. Ms. Gove, who has served as Chief Financial Officer of the Company since December 1997, will continue to retain that title. She was appointed Executive Vice President in July 1998, and served as Group Vice President from December 1997 to July 1998. From January 1996 to December 1997, she served as Senior Vice President, Corporate Planning and Analysis. From September 1996 through June 1997, Ms. Gove also served as Senior Vice President and Treasurer, overseeing Investor Relations and the Treasury, Tax and Control functions. Ms. Gove joined the Company in 1980 and served in numerous assignments until her appointment to Vice President in 1989.

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     Mr. David W. Howard was appointed Senior Vice President and Chief Information Officer in March 2001. Mr. Howard oversees the Company’s management information systems. Prior to re-joining the Company in March 2001, Mr. Howard was Vice President and Chief Information Officer for Cole National Corporation from October 2000 to March 2001. From April 1998 to September 2000, Mr. Howard served as Zale Corporation’s Senior Vice President of Management Information Systems and, prior to that position, he was Senior Vice President of Information Services for Sportmart, Inc., a publicly owned sporting goods chain, from November 1996 to April 1998.

Key Employees

     Ms. Pamela J. Romano joined the Company on September 22, 1997 as Senior Vice President and President of Zales Jewelers®. In January 2002, Ms. Romano assumed additional responsibility of Zales.com, the Company’s Web-based business. Prior to joining the Company, Ms. Romano held various merchandising positions with Macy’s.

     Ms. Charleen R. Wuellner was promoted to Senior Vice President and President, Gordon’s Jewelers® in April 2001. Ms. Wuellner was previously the President of Zales the Diamond Store Outlet®, to which she was appointed in August 2000. In August 1999, Ms. Wuellner was promoted to Senior Vice President of Zales the Diamond Store Outlet®. From April 1995 to August 1999, Ms. Wuellner held senior buying positions in Zales.com and Gordon’s Jewelers. Prior to joining the Company in April 1995, Ms. Wuellner held various merchandising positions with Macy’s.

     Mr. Charles E. Fieramosca joined the Company in April 2001 as Senior Vice President and President of Bailey Banks & Biddle Fine Jewelers®. In the 10 years prior to joining the Company, Mr. Fieramosca founded and served as the CEO of Ascend Consulting, a product and brand development company. Prior to his role at Ascend Consulting, Mr. Fieramosca held various positions with Jones New York Menswear, BASCO All American Sportswear, and Macy’s.

     Mr. Paul G. Leonard rejoined the Company in January 2002 and was appointed Senior Vice President and President of Piercing Pagoda®. From May 1999 to January 2002, Mr. Leonard served as Executive Vice President, Chief Merchandise and Marketing Officer, for Friedman’s Jewelers. From January 1998 to May 1999, Mr. Leonard served as Senior Vice President and President of Corporate Merchandising. From January 1995 to January 1998, Mr. Leonard served as President of Bailey Banks and Biddle Fine Jewelers®. Prior to joining the Company in 1994 as President of Corporate Merchandising, Mr. Leonard held various positions with Macy’s, the May Company, and Ames Department Stores.

     Mr. John A. Zimmermann joined the Company in May 2001 as Senior Vice President and President of Peoples Jewellers®. Prior to joining the Company, Mr. Zimmermann was the Senior Vice President of Merchandising, Planning and Sales Promotion for SmarterKids.com from June 1998 to May 2001. He served as Senior Vice President of Merchandising and Sales Promotion for Big Party from November 1996 to May 1998. Mr. Zimmermann’s background in retailing includes management positions for companies such as Federated Department Stores, where he served as Divisional Vice President for Women’s Fashion Accessories for The Bon Marché, and Bradley Stores Inc.

     Ms. Nancy O. Skinner was promoted to Vice President and Senior Vice President of Merchandising, Zales the Diamond Store Outlet® in April 2001. From May 1998 to April 2001, Ms. Skinner was a Diamond Buyer for Zales the Diamond Store Outlet®. Ms. Skinner joined the Company in April 1984 and has held numerous senior-buying positions in Diamond Park Fine Jewelers, Gordon’s Jewelers®, and Bailey Banks & Biddle Fine Jewelers®. Prior to joining the Company, Ms. Skinner held various merchandising positions with Gordon’s Jewelry Corporation.

     Mr. Gregory Humenesky was appointed Senior Vice President, Human Resources on April 15, 1996. From January 1995 to April 1996, Mr. Humenesky held the position of Vice President, Personnel Development and Staffing for the Company. Prior to joining the Company in 1995, Mr. Humenesky served in various positions in human resources with Macy’s.

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     Mr. Mark R. Lenz was appointed Senior Vice President, Controller on November 19, 1997. Mr. Lenz held various management positions in finance for the Company until his appointment to Vice President, Controller in February 1995. Prior to joining the Company in 1988, Mr. Lenz served in various positions in the audit division of Arthur Andersen LLP, in Dallas, Texas.

     Mr. Stephen C. Massanelli joined the Company on June 9, 1997 as Senior Vice President, Treasurer. From 1993 to 1997, Mr. Massanelli was a principal and member of the Board of Directors of The Treadstone Group, Inc., a private merchant banking organization in Dallas. Prior to 1993, Mr. Massanelli served in various financial roles in companies such as AMRESCO, Inc. and NationsBank of Texas.

     Mr. Ervin G. Polze was appointed Senior Vice President, Support Operations on January 17, 1996. From February 1995 through January 1996, he served as Vice President, Operations. Mr. Polze held the position of Vice President, Controller from March 1988 through February 1995. Mr. Polze joined the Company in January 1983 and served in several assignments until his appointment to Vice President in March 1988. Prior to 1983, Mr. Polze served in accounting roles with Contintal Emsco, a division of LTV Corporation.

     Mr. Robert A. Shapiro joined the Company in March 2001 as Senior Vice President, Real Estate. Prior to joining the Company, Mr. Shapiro was the founder and President of RetailEstate Advisors, Inc., a retail real estate consulting company whose clients included Gymboree and Eddie Bauer. Prior to his role at RetailEstate Advisors, Inc., Mr. Shapiro held various positions in real estate development, including Vice President for The Felenstein, Koniver, Stern Group, a national retail and real estate consulting company.

     Mr. George J. Slicho was appointed to the position of Senior Vice President, Loss Prevention in November 2000. Mr. Slicho began his career with the Company in March 1991 as Vice President of Loss Prevention. Prior to joining the Company, Mr. Slicho held various positions in corporate security, including Vice President of Loss Prevention and Audit for P.A. Bergner & Company.

     Ms. Hilary Molay was promoted to Vice President, General Counsel and Corporate Secretary of the Company in August 2002. Ms. Molay also serves as Secretary to the Zale Board of Directors. Previously, Ms. Molay served as Director, Senior Attorney for Zale Corporation, when she joined the Company in February 2000. Prior to working for the Company, Ms. Molay served in various legal positions, including Senior Attorney for JC Penney Company.

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PART II

     The Common Stock is listed on the New York Stock Exchange (“NYSE”) under the symbol “ZLC.” The following table sets forth the high and low sale prices for the Common Stock for each fiscal quarter during the two most recent fiscal years.

     As of September 17, 2002, the outstanding shares of Common Stock were held by approximately 940 holders of record. The Company has not paid dividends on the Common Stock since its initial issuance on July 30, 1993, and does not anticipate paying dividends on the Common Stock in the foreseeable future. In addition, the Company’s long-term debt limits the Company’s ability to pay dividends. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” and “Notes to the Consolidated Financial Statements — Long Term Debt.”

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     The following selected financial data is qualified in its entirety by the Consolidated Financial Statements of the Company (and the related Notes thereto) contained elsewhere in this Form 10-K and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The income statement and balance sheet data for each of the years ended July 31, 2002, 2001, 2000, 1999, and 1998 have been derived from the Company’s audited Consolidated Financial Statements.

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     With respect to forward-looking statements made in this Management’s Discussion and Analysis of Financial Condition and Results of Operations see “Business — Cautionary Notice Regarding Forward-Looking Statements on page 12.”

Results of Operations

     The following table sets forth certain financial information from the Company’s audited consolidated statements of operations expressed as a percentage of total revenues and should be read in conjunction with the Company’s Consolidated Financial Statements and Notes thereto included elsewhere in this Form 10-K.

     Zale Corporation and its wholly owned subsidiaries (the “Company”) is the largest specialty retailer of fine jewelry in North America. At July 31, 2002, the Company operated 2,295 specialty retail jewelry locations throughout the United States, Canada and Puerto Rico.

Year Ended July 31, 2002 Compared to Year Ended July 31, 2001

     Total Revenues. In fiscal year 2002, the Company focused on rebuilding and managing the business through the external volatility of the economy. The Company recorded total revenues of $2.192 billion in fiscal year 2002, an increase of 5.0 percent, over total revenues of $2.087 billion for the prior fiscal year.

     Comparable store sales increased 1.5 percent in fiscal year 2002 on a constant currency basis. Comparable store sales include sales for those stores that were in operation for a full 12-month period in both the current fiscal year and the prior fiscal year. The more moderate brands led the sales improvements, with the Zales brand comparative store sales increasing seven percent over the prior year. The high-end business was most affected by the uncertain economic environment, with a seven percent decrease in comparable store sales for the year. However, this business demonstrated improvement near the end of fiscal year 2002 compared to previous quarters. The revenue increase in comparable stores was attributable to continued strength in the bridal and solitaire categories. Three stone jewelry and signature stones were especially strong sellers. The Company attributes the strength of its diamond categories to improved merchandise quality and selection, along with an enhanced credit offering which has in turn improved the average check across all brands.

     The Company also believes that inventory management has positively affected sales. In fiscal year 2002, the Company has enhanced its focus on inventory management, adjusting inventory levels based on rate of sales in each store. This inventory management allowed stores to be in-stock on key items, as well as maintain current inventory levels.

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     Total Revenues include insurance premium revenues for credit insurance operations of $18.3 million and $19.0 million for fiscal years ended July 31, 2002 and 2001, respectively. These revenues were previously included in selling, general and administrative expenses as an offset to such expense. All periods presented have been reclassified to reflect this change.

     The Company opened 40 new stores during the year and closed 29 stores. In addition, the Company opened eight kiosks and closed 68 kiosks during the year. Most of these closures were Piercing Pagoda kiosks previously identified as under-performing locations at the time of the acquisition in September 2000.

     Gross Margin. In fiscal year 2002, Gross Margin as a percentage of revenues was 50.6 percent, an improvement of 1.4 percentage points over the same period in the prior year. Gross Margin in fiscal year 2001 included a nonrecurring charge of $25.2 million, or 1.2 percent of revenues, in January 2001, to adjust the valuation of certain inventory that was not of a quality consistent with the strategic direction of the Company’s brands. Gross margin was positively impacted in fiscal year 2002 by the reduced reliance on clearance merchandise and point of sale promotional activity. This improvement was offset by the higher proportion of sales in the bridal and solitaire categories that have a slightly lower margin rate. However, management believes the focus on inventory management and narrowing the assortment at certain stores contributes to improved margins by reducing markdowns.

     The LIFO inventory provision was $1.4 million for the year ended July 31, 2002, compared to a $4.9 million provision in the prior year. Prior to fiscal year 2002, the Company used the Bureau of Labor Statistics (“BLS”) producer price indices applied against inventory values to calculate the value of inventory on a LIFO basis. In fiscal year 2002, the Company applied internally developed indices that the Company believes more consistently measure inflation or deflation in the components of its merchandise (i.e., diamonds, gold and other metals and precious stones) and its merchandise mix. The Company believes the internally developed indices more accurately reflect inflation or deflation in its own prices than the BLS producer price indices. The impact on the individual prior years presented and the cumulative effect of this change on earnings at the beginning of fiscal year 2002 is not determinable. At the end of fiscal year 2002, the effect of using internal indices instead of the BLS’s producer price indices was to increase net income by approximately $4.8 million, or $0.14 per share. Adjustments to other inventory reserves for slow moving merchandise were $1.7 million and ($1.5) million for the years ended July 31, 2002 and 2001, respectively. See — “Critical Accounting Policies.”

     Selling, General and Administrative Expenses. Selling, General and Administrative Expenses (“SG&A”) increased 0.6 percentage points to 39.8 percent of revenues for the year ended July 31, 2002 from 39.2 percent for the year ended July 31, 2001.

     Store expenses such as rent and occupancy increased 0.7 percent of revenues principally as a result of increasing lease costs for both lease renewals and new leases. Payroll expenses increased 0.4 percent of revenues. Advertising costs decreased 0.9 percent of revenues, due to the Company’s decision to allocate resources towards creating a more competitive credit offering. This expanded twelve-month interest free credit offering resulted in increased credit expense of 0.9 percent of revenues. Corporate expenses remained relatively flat as a percent of revenues.

     Cost of Insurance Operations. The Cost of Insurance Operations, which was previously netted with insurance premium revenue in SG&A, increased 0.1 percent of revenues over the prior year. These costs were reclassed to a separate line on the Income Statement to improve business reporting.

     Unusual Item — Executive Transactions. Robert J. DiNicola retired as Chief Executive Officer at the end of fiscal year 2002. In connection with his retirement, the Company agreed to pay certain expenses on an ongoing basis including life insurance premiums, relocation and medical costs totaling $0.8 million. He will remain Chairman of the Board in a non-executive role, and has entered into a consulting agreement with the Company.

     In addition, Alan P. Shor resigned as President and Chief Operating Officer at the end of fiscal year 2002. In connection with his resignation, the Company agreed to pay over a three year period certain benefits of approximately $1.5 million consisting principally of an amount equivalent to three years of salary and other related benefits, including accelerated vesting of restricted stock. Mr. Shor also received accelerated vesting of certain stock options.

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     In fiscal year 2001, Executive Transaction charges included the effect of the resignation of Beryl B. Raff, who resigned as Chairman of the Board and Chief Executive Officer in February 2001. In connection with her resignation, the Company agreed to pay certain benefits of approximately $2.5 million consisting principally of an amount equivalent to three years of salary and other severance related benefits, including accelerated vesting of certain options and restricted stock. Also in fiscal year 2001, Robert J. DiNicola retired as Chairman of the Board in September 2000. In connection with his severance arrangement, the Company paid certain benefits of approximately $1.9 million consisting principally of an amount equivalent to one year of salary and bonus and other severance related benefits, including the accelerated vesting of certain options held by Mr. DiNicola. Mr. DiNicola returned to the Company in February 2001 at the request of the Board of Directors.

     Unusual Item — Retiree Medical Plan Curtailment Gain. In January 2002, the Company amended its Retiree Medical plan to limit retiree health coverage to only those retirees who were already participants in the plan and to those otherwise eligible employees who elected to retire prior to April 1, 2002. Retiree health benefits will no longer be available to those current employees who were previously in the eligible class of employees (i.e., those hired prior to November 15, 1994, if they retired at age 55 or older with 10 or more years of continuous service). In January 2002, the Company recorded a $3.5 million gain related to this curtailment of its retiree medical plan.

     Depreciation and Amortization Expense. Depreciation and Amortization Expense remained unchanged compared to the prior year, primarily as a result of the elimination of goodwill amortization and the excess of revalued net assets (negative goodwill) amortization, due to the adoption of SFAS No. 141 and 142 on August 1, 2001. This adoption resulted in a decrease in net amortization expense for the fiscal year 2002 of approximately $5.9 million. This decrease is offset by additional depreciation from the purchase of new assets, principally for new store openings, renovations and refurbishments.

     Interest Expense, Net. Interest Expense, Net was $7.8 million and $6.9 million for the years ended July 31, 2002 and 2001, respectively. The increase of $0.9 million is primarily a result of reduced interest income (which offsets interest expense) as compared to the same period in the prior year. During the first two months of the first quarter of fiscal year 2001, the Company invested cash proceeds from the sale of its customer receivables in interest earning assets. A significant portion of those cash proceeds were subsequently used to acquire Piercing Pagoda, Inc. in September 2000 and to pay down debt. Additionally, the Company repurchased $13 million of Senior Notes on the open market in June 2002, for which it incurred an $0.8 million loss on extinguishment of debt recorded in Interest Expense. This repurchase reduced interest expense owed to the note holders in fiscal year 2002 by $0.2 million.

     Income Taxes. The income tax expense for the years ended July 31, 2002 and 2001 was $59.3 million and $51.3 million, respectively, reflecting an effective tax rate of 36.6 and 38.5 percent for the years ended July 31, 2002 and 2001, respectively. The decrease in the effective rate is principally due to the elimination of the goodwill amortization in the current year due to the adoption of SFAS Nos. 141 and 142 on August 1, 2001 and a decrease in the state effective tax rate. The Company may realize a cash benefit from utilization of tax net operating loss carryforwards (“NOL”) (after annual limitations of $19.5 million) against current and future tax liabilities. As of July 31, 2002, the Company had a remaining NOL (after limitations) of $130 million.

     Effect of a Change in Accounting for the Write Off of the Excess of Revalued Net Assets Over Stockholders’ Investment. On July 21, 2001, the Financial Accounting Standards Board issued SFAS No. 141 “Business Combinations.” SFAS No. 141 establishes specific criteria for the recognition of intangible assets subsequent to their acquisition, including negative goodwill. Negative goodwill related to future acquisitions should be recorded as an extraordinary item. In addition, upon adoption, existing negative goodwill (or excess of revalued net assets over stockholders investment) should be written off as a change in accounting principle. The Company adopted SFAS No. 141 in the first quarter of fiscal year 2002. As a result, the Company wrote off the Excess of Revalued Net Assets Over Stockholders’ Investment (negative goodwill) and recognized income of approximately $41.3 million in the first quarter of fiscal year 2002.

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Year Ended July 31, 2001 Compared to Year Ended July 31, 2000

     Total Revenues. During fiscal year 2001, the Company recorded total revenues of $2.087 billion, an increase of 13.8 percent, over total revenues of $1.834 billion for the prior fiscal year. Sales related to the kiosk operations acquired in September 2000 accounted for substantially all of the total revenue increase. Excluding the kiosk operations, sales remained relatively flat over prior year, despite 64 new stores added during the year (which was offset by 26 stores closed during the year).

     Comparable store sales decreased 3.8 percent in fiscal year 2001 on a constant currency basis. Comparable store sales include sales for those stores which were in operation for a full period in both the current fiscal year and the prior fiscal year. Management believes the sales reduction in comparable stores was attributable to merchandising decisions early in the year. In the first half of the year, the Company focused more on promotional items at higher markdowns to increase the volume in a period of softening sales, while the spring brought a renewed focus on improving the quality of the inventory.

     Management believes that sales were negatively affected as a result of the effort to realign inventory, subsequent to the Company’s change in management. During the last half of the fiscal year, the Company was focusing on the effort to liquidate or realign inventory that did not meet the Company’s strategic direction.

     Sales focus has shifted to reemphasize the bridal category. Offsetting the negative factors above, the Company benefited in fiscal year 2001 from strong sales of certified diamonds and proprietary diamonds, such as the 82 faceted “Zales Diamond,” which were well received and strengthened the solitaire merchandise mix. Total revenues also include insurance premium revenues previously included in SG&A. All periods have been reclassified to reflect the change.

     Gross Margin. Gross Margin as a percentage of revenues remained relatively flat compared to the prior year at 49.2 percent of total revenues. The Company recorded a non-recurring charge of $25.2 million in the second quarter to adjust the valuation of certain inventory that was not of a quality consistent with the strategic direction of the Company’s brands. The negative impact to margin from the non-recurring charge of 1.2 percent of revenues is offset by the addition of the kiosk operations, which have a higher gross margin rate than the rest of the Company’s in-line stores. Gross margin was also negatively impacted by increased markdowns and point of sale promotional activity used to liquidate excess inventory. The LIFO provision was $4.9 million for the year ended July 31, 2001, compared to a $3.0 million benefit in the prior year.

     Selling, General and Administrative Expenses. Selling, General and Administrative Expenses (“SG&A”) increased 4.1 percent to 39.2 percent of total revenues for the year ended July 31, 2001 from 35.1 percent for the year ended July 31, 2000. Approximately 1.4 percent of this increase is principally due to the acquisition of the kiosk operations in September 2000. This business has significantly higher store expense as a percentage of revenues than traditional store formats.

     Excluding the kiosk operations, SG&A expenses were 37.8 percent of revenues, an increase of 2.7 percentage points over the prior year. While payroll expenses remained flat as a percentage of revenues, other store expenses such as rent and occupancy and business expenses increased 0.8 percent of revenues principally as a result of increasing rents for both existing and new stores during a period with lower sales. Advertising costs rose 0.6 percent of revenues, as increased advertising expenses in fiscal year 2001 did not result in a proportionate increase in sales revenue. These increases were partially offset by the Company’s ability to leverage its fixed corporate overhead, which decreased 0.4 percent of revenues.

     Approximately 1.6 percentage points of the increase in SG&A expense as a percentage of revenues is due to the outsourcing of the Company’s customer accounts receivables program to a third party. In the prior year, amounts related to the customer receivables for finance charge income, net of customer receivable account charge-offs and credit operating expenses, were included as a net reduction in SG&A expense. Subsequent to the outsourcing agreement, only the merchant fees charged by the third party outsourcer to process customer receivables are included as a charge in SG&A expense. Also as a result of the outsourcing, interest expense has been significantly reduced as there is no longer a requirement to finance those customer receivables.

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     Cost of Insurance Operations. The Cost of Insurance Operations, which was previously netted with insurance premium revenue in SG&A, remained flat as a percentage of total revenues.

     Unusual Item — Executive Transactions. Effective September 6, 2000, Robert J. DiNicola retired as Chairman of the Board. In connection with his severance arrangement, the Company paid certain benefits of approximately $1.9 million consisting principally of an amount equivalent to one year of salary and bonus and other severance related benefits including the accelerated vesting of certain options held by Mr. DiNicola.

     Effective February 12, 2001, Beryl B. Raff resigned as Chairman of the Board and Chief Executive Officer. In connection with her resignation, the Company agreed to pay certain benefits of approximately $2.5 million consisting principally of an amount equivalent to three years of salary and other severance related benefits including accelerated vesting of certain options and restricted stock.

     Depreciation and Amortization Expense. Depreciation and Amortization Expense increased by $15.9 million, primarily as a result of goodwill amortization from the acquisition of Piercing Pagoda and depreciation from the purchase of new assets, principally for new store openings, renovations and refurbishments.

     Interest Expense, Net. Interest Expense, Net was $6.9 million and $32.2 million for the years ended July 31, 2001 and 2000, respectively. The decrease of $25.3 million is primarily because the Company is no longer required to finance its customer receivables, as a result of the sale of these receivables to Citi Commerce Solutions.

     Income Taxes. The income tax expense for the years ended July 31, 2001 and 2000 was $51.3 million and $66.7 million, respectively, reflecting an effective tax rate of 38.5 and 37.4 percent for the years ended July 31, 2001 and 2000, respectively. The increase in the effective rate is due to nondeductible goodwill amortization from the Piercing Pagoda acquisition. The Company may realize a cash benefit from utilization of NOL (after annual limitations of $19.5 million) against current and future tax liabilities. As of July 31, 2001, the Company had a remaining NOL (after limitations) of $152.9 million.

Liquidity and Capital Resources

     The Company’s cash requirements consist principally of funding inventory growth, capital expenditures primarily for new store growth and renovations, upgrading its management information systems and debt service. As of July 31, 2002, the Company had cash and cash equivalents of $84.9 million, and no restricted cash. The retail jewelry business is highly seasonal, with a significant proportion of sales and operating income being generated in November and December of each year. Approximately 41 percent and 42 percent of the Company’s annual revenues were made during the three months ended January 31, 2002 and 2001, respectively, which include the Holiday selling season. The Company’s working capital requirements fluctuate during the year, increasing substantially during the fall season as a result of higher planned seasonal inventory levels.

Operating Activities

     Net cash provided by operating activities was $173.2 million, $89.0 million and $140.9 million for fiscal years 2002, 2001, and 2000, respectively. The net cash provided by operating activities increased from the prior year, principally due to the timing of payments of accounts payable, including taxes payable, and accrued liabilities. In fiscal year 2000, the net cash provided by operating activities resulted principally from net earnings and effective inventory management resulting in the leveraging of accounts payable and accrued liabilities, offset by cash requirements of owning the customer accounts receivable.

     There has been an increase of approximately $58.2 million in owned merchandise inventories at July 31, 2002 compared to the balance at July 31, 2001. This increase resulted principally from the timing of receipts, as purchasing had been curtailed significantly and returns of inventory not consistent with the Company’s strategy were under way at July 31, 2001.

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     Net cash used in investing activities was $49.2 million in fiscal year 2002, related to capital expenditures for new store openings, renovations and refurbishments and net purchases of investments. In fiscal year 2001, net cash used in investing activities was $323.8 million, principally related to the acquisition of Piercing Pagoda, as well as $88 million in capital expenditures. In fiscal year 2000, net cash provided by investing activities was $509.3 million, principally related to the proceeds from the sale of credit card receivables to Citi Commerce Solutions, offset by capital expenditures.

     Net cash used in financing activities was $68.4 in fiscal year 2002, principally related to the stock repurchase plan approved in July 2001, as well as the fiscal year 2003 stock repurchase plan which commenced in July 2002. The Company also repurchased on the open market and cancelled $13.0 million of Senior Notes in the fourth quarter of 2002 for which in incurred an $0.8 million loss on extinguishment of debt. Net cash used in financing activities was $34.0 million in fiscal year 2001, principally related to the stock repurchase plan approved in July 2000 and the repayment of long-term debt acquired in the Piercing Pagoda acquisition, slightly offset with proceeds from the exercise of stock options. Net cash used in financing activities was $387.4 million in fiscal year 2000, principally related to the repayment of the Variable Funding Notes (debt requirements of owning the customer accounts receivable) and Revolving Credit Agreement, as well as the stock repurchase plan approved in September 1999.

Finance Arrangements

     In order to support the Company’s growth plans, the Company amended and restated its unsecured Revolving Credit Agreement on March 30, 2000. The Revolving Credit Agreement provides for (i) a U.S. Revolving Credit facility to the Company and to its operating subsidiary, Zale Delaware, Inc., in the aggregate principal amount of up to $215 million in commitments by certain U.S. lenders, including a $10 million sublimit for letters of credit, and (ii) a separate Canadian Revolving Credit facility for a Canadian subsidiary, which provides for Canadian dollar denominated loans in the aggregate principal amount of up to a U.S. Dollar equivalent of approximately $10 million in commitments by a Canadian lender. The total amount of commitments under the Revolving Credit Agreement to the Company and its subsidiaries is approximately $225 million and the term is five years. Under the Revolving Credit Agreement the Company may, subject to approval of the U.S. Agent or the Canadian Agent, as the case may be, increase the total U.S. commitment to $285 million and the Canadian commitment to U.S. Dollar equivalent of $25 million provided that the commitments together do not exceed U.S. Dollar equivalent of $300 million.

     The revolving credit loans bear interest at floating rates as follows: (A) loans outstanding under the U.S. Revolving Credit Facility bear interest, at the Company’s option, at either (i) the applicable Eurodollar Rate plus a margin equal to 0.50 percent (subject to adjustment as described below), or (ii) the Base Rate (which is the higher of the annual rate of interest announced from time to time by the agent bank under the Revolving Credit Agreement as its base rate or the Federal Funds Effective Rate plus 0.5 percent); and (B) loans outstanding under the Canadian Revolving Credit Facility bear interest, at the Company’s option, at either (i) Bankers’ Acceptance Discount Rate (which varies depending upon whether the Canadian Lender is a bank named under Schedule I or II to the Bank Act (Canada or neither) plus a margin equal to 0.50 percent (subject to adjustment as described below), or (ii) the annual rate of interest announced from time to time by the Canadian agent bank under the Revolving Credit Agreement as its “prime rate” for commercial loans in Canadian dollars to borrowers in Canada. At July 31, 2002, there were no amounts outstanding under the U.S. Revolving Credit Facility or the Canadian Revolving Credit Facility.

     In order to support the Company’s longer term capital financing requirements, the Company issued $100 million of Senior Notes (the “Senior Notes”) on September 23, 1997. These notes bear interest at 8 1/2 percent and are due in 2007. In fiscal year 2002, the Company repurchased on the open market and cancelled $13 million of the Senior Notes. The Company recognized a $0.8 million loss on the extinguishment of debt in fiscal year 2002. The remaining $87 million of Senior Notes are unsecured. The indenture relating to the Senior Notes contains certain restrictive covenants including but not limited to limitations on indebtedness, limitations on dividends and other restricted payments (including repurchases of the Company’s common stock), limitations on transactions with affiliates, limitations on liens and limitations on disposition of proceeds of asset sales, among others. Pursuant to the Indenture, the Company and the Company’s subsidiaries subject to the Indenture, are prohibited from paying any dividend to the direct or indirect holders of capital stock of the Company or such subsidiary, other than stock dividends or dividends made to the Company or any such subsidiary.

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Capital Growth

     During the year ended July 31, 2002, the Company made $54 million in capital expenditures, a portion of which was used to open 48 new locations and remodel, relocate or refurbish other locations. As a result of current business conditions, the Company has continued to scale back its capital plan. The Company plans to open 60 new locations, including 30 new kiosks, for which it will incur $10 million in capital expenditures during fiscal year 2003. During fiscal year 2003, the Company anticipates spending $33 million to remodel, relocate or refurbish 226 additional locations. This will allow the Company to focus on productivity of existing core store locations. The Company also estimates that it will make capital expenditures of $9 million during fiscal year 2003 for enhancements to its management information systems and infrastructure expansion. In total, the Company anticipates spending $64 million on capital expenditures during fiscal year 2003. The Revolving Credit Agreement limits the Company’s capital expenditures to $145 million for fiscal year 2003.

Other Activities Affecting Liquidity

     •     Contractual obligations — Aggregated information about the Company’s contractual obligations as of July 31, 2002 is presented in the following table.

     •     In the fourth quarter of fiscal year 2002, the Company repurchased on the open market and cancelled $13 million of Senior Notes. The Company recognized an $0.8 million loss related to this extinguishment of debt. This loss is reported in net interest expense on the Statement of Operations.

     •     On July 17, 2002, the Company announced that its Board of Directors had approved a stock repurchase program under which the Company, from time to time and at management’s discretion and in accordance with the Company’s usual policies and applicable securities laws, may purchase up to an aggregate of $50 million of Zale common stock on the open market through July 31, 2003. Under this program, the Company had purchased 0.2 million shares at an aggregate cost $4.4 million through July 31, 2002.

     •     The Company has an operations services agreement with a third party for the management of the Company’s mainframe processing operations, client server systems, Local Area Network operations and desktop support. The agreement, which was effective August 1, 2002, requires fixed payments totaling $11 million over a 36-month term and a variable amount based on usage. The Company has an option to extend the current agreement for two consecutive one year periods.

     •     Future liquidity will be enhanced to the extent that the Company is able to realize the cash benefit from utilization of its NOL against current and future tax liabilities. The cash benefit realized in fiscal year 2002 was approximately $9 million. As of July 31, 2002, the Company had a NOL (after limitations) of $130 million, which represents up to $50 million in future tax benefits. The utilization of this asset is subject to limitations. The most restrictive is the Internal Revenue Code Section 382 annual limitation of $19.5 million. The NOL can be utilized through 2008.

     Management believes that operating cash flow and amounts available under the Revolving Credit Agreement should be sufficient to fund the Company’s current operations, debt service and currently anticipated capital expenditure requirements for the foreseeable future.

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New Accounting Pronouncements

     In October 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The Company will adopt SFAS No. 143 as required for the first quarter of fiscal year 2003. The Company does not expect that SFAS No. 143 will have a material impact on its results of operations or financial position.

     In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 primarily affects the reporting requirements and classification of gains and losses from the extinguishment of debt, rescinds the transitional accounting requirements for intangible assets of motor carriers, and requires that certain lease modifications with economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. SFAS No. 145 is effective for financial statements issued after April 2002, with the exception of the provisions affecting the accounting for lease transactions, which should be applied for transactions entered into after May 15, 2002, and the provisions affecting classification of gains and losses from the extinguishment of debt, which should be applied in fiscal years beginning after May 15, 2002. The Company early adopted this statement in the fourth quarter of 2002. Thus, the Company’s $0.8 million loss on extinguishment of debt is included in net interest expense, and is not reported as an extraordinary item.

     The Financial Accounting Standards Board recently issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 requires all restructurings initiated after December 31, 2002 to be recorded when they are incurred and can be measured at fair value, with the recorded liability subsequently adjusted for changes in estimated cash flows. SFAS No. 146 will impact the timing of when costs associated with any future exit or disposal activity are recognized in the financial statements.

Inflation

     In management’s opinion, changes in net revenues, net earnings, and inventory valuation that have resulted from inflation and changing prices have not been material during the periods presented. The trends in inflation rates pertaining to merchandise inventories, especially as they relate to gold and diamond costs, are primary components in determining the Company’s LIFO inventory. There is no assurance that inflation will not materially affect the Company in the future.

Critical Accounting Policies

     The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. For example, unexpected changes in market conditions or a downturn in the economy could adversely affect actual results. Estimates are used in accounting for, among other things, inventory obsolescence, goodwill valuation, LIFO inventory retail method, legal liability, credit insurance liability, product warranty, depreciation, employee benefits, taxes, and contingencies. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the Consolidated Financial Statements in the period they are determined to be necessary.

     Management believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its Consolidated Financial Statements.

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     Merchandise Inventories — Merchandise Inventories are stated at the lower of cost or market. Substantially all U.S. inventories represent finished goods which are valued using the last-in, first-out (“LIFO”) retail inventory method. Merchandise inventory of Peoples Jewellers of Canada is valued using the first-in, first-out (“FIFO”) retail inventory method. Under the retail method, inventory is segregated into categories of merchandise with similar characteristics at its current retail selling value. The determination of inventory at cost and the resulting gross margins are calculated by applying an average cost to retail ratio to the retail value of inventory. The cost to retail ratio for each merchandise category is based on beginning inventory and fiscal year purchase activity for each category.

     The Company is required to determine the LIFO cost on an interim basis by estimating annual inflation trends, annual purchases and ending inventory levels for the fiscal year. Actual annual inflation rates and inventory balances as of the end of any fiscal year may differ from interim estimates. Prior to fiscal year 2002, the Company used the Bureau of Labor Statistics (“BLS”) producer price indices applied against inventory values to calculate the value of inventory on a LIFO basis. In fiscal year 2002, the Company applied internally developed indices that the Company believes more consistently measure inflation or deflation in the components of its merchandise (i.e., diamonds, gold and other metals and precious stones) and its merchandise mix. The Company believes the internally developed indices more accurately reflect inflation or deflation in its own prices than the BLS producer price indices. The impact on the individual prior years presented and the cumulative effect of this change on earnings at the beginning of fiscal year 2002 is not determinable. At the end of fiscal year 2002, the effect of using internal indices instead of the BLS producer price indices was to increase net income by approximately $4.8 million, or $0.14 per share.

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

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

     Long-lived Assets and Goodwill — Long-lived assets are periodically reviewed for impairment by comparing the carrying value of the assets with their estimated fair values. If the evaluation indicates that the carrying amount of the asset may not be recoverable, the potential impairment is measured based on a projected discounted cashflow method, using a discount rate that is considered to be commensurate with the risk inherent in the Company’s current business model. Assumptions are made with respect to cash flows expected to be generated by the related assets based upon updated projections. Any changes in key assumptions or market conditions could result in an unanticipated impairment charge. For instance, in the event of a major market downturn, individual stores may become unprofitable, which could result in a writedown of the carrying value of the assets located in those stores. Any impairment would be recognized in operating results if a permanent reduction were to occur.

     Goodwill, which represents the cost in excess of fair value of net assets acquired, is subject to an impairment test on an annual basis, or when there is reason to believe that the value has been diminished or impaired. The fair value of the Company’s identified reporting units was estimated using the expected present value of corresponding future cash flows and market values of comparable businesses where available. The Company completed the valuations of its reporting units that include goodwill in fiscal year 2002 and concluded that no impairment of goodwill existed.

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     Revenue Recognition — The Company recognizes revenue in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial Statements” (“SAB 101”). Revenue related to merchandise sales is recognized at the time of the sale, reduced by a provision for returns. The provision for sales returns is based on historical evidence of the Company’s return rate. Repair revenues are recognized when the service is complete and the merchandise is delivered to the customers. Total Revenues include extended service agreements (“ESA”) which are recognized over the period the services are performed. Revenues also include premiums from the Company’s insurance businesses, principally related to credit insurance policies sold to customers who purchase the Company’s merchandise under the proprietary credit program. Insurance premiums are recognized over the coverage period.

     Other Reserves — The Company is involved in a number of legal and governmental proceedings as part of the normal course of business. Reserves are established based on management’s best estimates of the Company’s potential liability in these matters. These estimates have been developed in consultation with in-house and outside counsel and are based on a combination of litigation and settlement strategies.

     Income taxes are estimated for each jurisdiction in which the Company operates. This involves assessing the current tax exposure together with temporary differences resulting from differing treatment of items for tax and accounting purposes. Any resulting deferred tax assets are evaluated for recoverability based on estimated future taxable income. To the extent that recovery is deemed not likely, a valuation allowance is recorded. The Company believes that as of July 31, 2002 the realization of the deferred income tax asset is more likely than not, and thus there was no valuation reserve recorded.

     The Company is exposed to market risk from changes in interest rates which may adversely affect its financial position, results of operations and cash flows. In seeking to minimize the risks from interest rate fluctuations, the Company manages exposures through its regular operating and financing activities. The Company does not use derivative financial instruments for trading or other speculative purposes and is not party to any leveraged financial instruments.

     The Company is exposed to interest rate risk primarily through its borrowing activities, which are described under “Long-term Debt” in the Notes to the Consolidated Financial Statements. However, the majority of the Company’s borrowings outstanding at July 31, 2002 are under fixed rate arrangements. See “Long-term Debt” in the Notes to the Consolidated Financial Statements, which are incorporated herein by reference.

     The investments of the Company’s insurance subsidiaries, primarily stocks and bonds in the amount of $26.7 million, approximate market value at July 31, 2002.

     Based on the Company’s market risk sensitive instruments (including variable rate debt) outstanding at July 31, 2002, the Company has determined that there was no material market risk exposure to the Company’s consolidated financial position, results of operations or cash flows as of such date.

     Commodity Risk — The Company principally addresses commodity risk through retail price points. The Company’s commodity risk exposure to diamond and gold market price fluctuation is not currently hedged by financial instruments. As gold prices have shown more volatility over the past year, the Company is reviewing its options to mitigate the risk of price increases including timing of commodity purchases or hedging.

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     Foreign Currency Contracts — As a result of its Canadian operations, the Company is exposed to market risk from currency exchange rate exposure which may adversely affect the Company’s financial position, results of operations and cash flows. In seeking to minimize this risk, the Company manages exposures through forward exchange hedge contracts. Based on the Company’s market risk from currency exchange rate exposure at July 31, 2002, the Company believes that there was no material market risk exposure to the Company’s consolidated financial position, results of operations or cash flows on such date. The table below provides information about the Company’s derivative financial instruments that are sensitive to foreign currency exchange rates and presents such information in U.S. dollar equivalents as that is the Company’s reporting currency.

Forward Exchange Agreements
(USD equivalent)

     The Company generally enters into foreign currency contracts with maturity dates of twelve months or less.

     Energy Contract — The Company fixed the prices of certain electricity purchases under an electricity requirements contract. The contract is for a three-year period and is with a utility company to purchase electricity in the State of Texas. This contract qualifies as a “normal purchase” under SFAS 138; accordingly, the fair value of the contract is not required to be recorded on the balance sheet. Payments under this contract are expected to approximate $750,000 annually based on current usage patterns.

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     The following Consolidated Financial Statements of the Company and supplementary data are included as pages F-1 through F-41 at the end of this Annual Report on Form 10-K:

     In June 2002, the Company announced that the Board of Directors, upon recommendation of its Audit Committee, ended the engagement of Arthur Andersen LLP as the Company’s independent public accountants, and engaged KPMG LLP to serve as the Company’s independent public accountants for the fiscal year ending July 31, 2002. For more information, see the Company’s current report on Form 8-K, filed with the SEC on June 6, 2002.

PART III

     The information set forth under the headings “Proposal No. One: Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive Proxy Statement for the 2002 Annual Meeting of Shareholders is incorporated herein by reference. In addition, the information set forth under “Executive Officers of the Registrant” in Part I of this report is incorporated herein by reference.

     The information set forth under the heading “Executive and Director Compensation” in the Company’s definitive Proxy Statement for the 2002 Annual Meeting of Shareholders is incorporated herein by reference.

     The information set forth under the heading “Outstanding Voting Securities of the Company and Principal Holders Thereof” in the Company’s definitive Proxy Statement for the 2002 Annual Meeting of Shareholders is incorporated herein by reference.

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Equity Compensation Plan Information

     The following table gives information about common stock that may be issued upon the exercise of options, warrants and rights under all existing equity compensation plans as of July 31, 2002.

Equity Compensation Plan Information

     The information set forth under the headings “Certain Relationships and Transactions” in the Company’s definitive Proxy Statement for the 2002 Annual Meeting of Shareholders is incorporated herein by reference.

     There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls since the date of the Company’s last evaluation of internal controls.

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PART IV

     The following documents are filed as part of this report.

1.     Financial Statements

     The list of financial statements required by this item is set forth in Item 8.

2.     Index to Financial Statement Schedules

     All other financial statements and financial statement schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions, are not material or are not applicable and, therefore, have been omitted or are included in the consolidated financial statements or notes thereto.

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3.     Exhibits

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