GLG News by Nicholas White

Implications: With about 46% of Zale's stock float sold short, short sellers will be the only beneficiaries of Goldberg's "sweeping' management changes.  Here is why.

Analysis: Zale stock moved higher today on news that Theo Killion had been promoted to president of the fine jewelry retailer.  Most recently, Killion was the EVP for Human Resources.  He was also responsible for the company’s Legal and Corporate Strategy functions.  Now as president he will direct Loss Prevention, Customer Service, and Store Operations.  Excluded from his responsibilities are the critical buying, merchandising, marketing, finance, and accounting functions which will continue to report to Neil Goldberg who will remain CEO.  In a separate announcement, the company also said Mary Kwan, the former Chief Merchandise Officer for the soft lines retailer Goody’s Family stores would assume the responsibility of EVP and Chief Merchandising Officer for Zale.  

Evidently some institutional buyers liked the announcement as Zale stock price advanced about 13% on strong volume.  Zale is scheduled to report 4th quarter and FY 2008 YE earnings on August 28th.  Most analysts expect the company to report a loss between ($0.44) per share and ($0.66) per share for the last quarter of its 2008 fiscal year that ended July 31st.  Moving forward, current estimates are the company will earn between $0.45 and $1.30 per share for FY 2009.  

That seems very optimistic given current economic trends and the company’s deep discount driven sales base.  The fact is there are few signs that consumer sending will rebound during the last calendar quarter of 2008.  While, the stimulus package injected more than $100 billion into the economy, the results were mixed, especially for jewelry retailers like Zale.  For the most part, higher prices for fuel and food offset any incremental buying leverage the additional income gave consumers.  Now that most of the rebate has been distributed, consumers will probably spend most of it by the beginning of the October.  That means the economy could slow even further during the last three months of 2008 when Zale earns nearly 100% of its annual profit.  

Another stumbling block the company faces is a weak sales base.  By weak, I mean the company was on sale with a combination of high discounts, rebates, and clearance events last Christmas.  This year,   Zale is up against the sales generated by those events with weaker assortments and an even weaker economy.  Add the company has been on sale at up to 70% off for the last 7 months which will have cannibalized some future sales, as well as, set consumer pricing expectations for the fall, and you have an unusually hostile sales environment, much of which is of current management’s own making.  

Unfortunately, it doesn’t get better for Zale.  Most economists now believe the first three to six months of 2009 could also be weak.  Zale will be up against the beginning of its $100 million inventory clearance sale which it can’t match off without continued high discounting or a significant investment in inventory in combination with margin improvement.  If that hasn’t already happened by December, it’s not going to happen in Zale’s second half either.  Accordingly, last years clearance sales will probably decline faster than regular margin sales increase this year which probably means more losses for the company in FY 2009, That's in contrast to the earnings turn around shareholders currently expect.  Now, the real question for investors is: Are things better at Zale, the same or getting worse?    

It’s problematic whether Chairman Lowe has a better handle on the company’s strategic issues than Richard Marcus, Zale’s previous chairman.  Likewise, it’s hard to see how Goldberg’s selection as CEO is superior to the  boards choice of either Burton or Forte several years earlier, especially after his recent organizational changes, including the appointment of a soft goods merchandiser as Zale’s chief  diamond merchant.  Evidently Goldberg thinks buying, merchandising, marketing, and selling fine jewelry is essentially the same as selling blue jeans, plus sized women’s cloths, and discount apparel. 

If true, it's categorically incorrect and there’s a list of jewelry businesses that demonstrate it.  Most recently you only have to point to the liquidation of Friedman’s 400 stores and the pending closure of Whitehall Jeweler’s 375 store chain to illustrate the point.  Some would argue Robert DiNicola was an example of a non- jewelry CEO that was successful at Zale.  However, despite the appearance of a turn around in the mid 1990’s, a critical examination of his department store methods suggests big box sourcing, quality, and pricing methods laid the foundation for many of Zale’s current problems.  A point further born out by the recent bankruptcy of Linens and Things, another up market better goods, specialty retailer where DiNicola was last CEO.

Moving forward, as far as the company future earnings are concerned, poor mix, broken assortments, misguided styling, and rampant discounting will continue to inhibit Zale’s recovery for at least another Christmas or two as one more inexperienced soft lines merchandiser finds out too late that the experience curve in fine jewelry retailing is steeper than imagined and the business more complex than anticipated.  While that’s bad news for many Zale investors, it could be really good news for speculators that have sold Zale stock short.  

Selling for more than 150% of its 52 week low, about 46% of Zale’s float has been sold short.  In comparison, only Blue Nile has a greater percentage of its float short sold (61%), followed by Tiffany (10%), and Signet Group (0.18%).  In spite of Zale’s increasing stock price, many speculators are hedging their investment, betting Zale management will under perform, yet again, this Christmas and with good reason considering the economy, inexperienced management, and stocks previous trading history.   

For example, Zale’s share price has declined by more than 11% between August 1st and January 31st over the past four years.  Specifically, the stock was higher only one year out of the last four on January 31st; declining (4.4%), (27.2%), and (21.9%) in the other three years.  So, short selling now could lead to big trading profits if stock prices decline after Christmas 2008 as it has in three of the last four years.  If that happens short sellers will be the only real winners, leaving smaller institutions trying to liquidate their positions before the big hedge fund share holders like Richard Breeden find a quick exit strategy. 

Implications: Congressional action to ban the Import of Burmese gemstones could mean higher gross margins for Tiffany.  Here's why.

Analysis: Candidly, I am always skeptical when the Congress votes to ban, restrict, or limit the import, export, or sale of any product, especially on the grounds that it is for the good of all mankind.  That isn’t to say that there aren’t many worth causes that could use legislative support.  But realistically, there are almost always big financial winners anytime Congress legislates ether an increase or decrease in actual supply and demand of any product.  

Take the recent legislation halting the importation of Burmese rubies into the US.  Like almost every natural gemstone, fine rubies have significantly appreciated in value over the last 20 years.  Burmese rubies are no different.  In fact, it’s difficult to find high quality gemstones in the marketplace today.  That’s not because there are none, but for the most part very few are for sale.   Now there will be even less, so the value of the exiting stones will escalate even higher, encouraging smugglers to take even higher risks to transport Burmese stones to free ports of entry.   

For those stone merchants that currently own Burmese stones, their inventories may well have doubled in value.  For those who own jewelry set with the little red gems, their heirs will be happy to lean that mom’s 3 carat ruby ring is now worth more than the cost of an Ivy League education; a value that probably will not decrease even if some political and social stability is attained in the troubled regions.  

Likewise, retailers like Tiffany, Cartier, Harry Winston, and Garrard can not only describe their signature ruby rings, necklaces, scatter pins, bracelets, and tiaras as historical heirlooms worthy of even higher value, but also increase the prices of both their estate and modern styles pieces offered for sale in showrooms around the world.  

Congresses action is hardly a unique event, earlier it passed legislation regarding the import of “blood diamonds” that where being sold by rebels to fund a Civil War in Angola. One consequence of that legislation was the creation the Kimberly Process where by the diamond industry agreed to an administrative process to limit the trading in “conflict diamonds”  Hailed by activist’s groups as a measure to bring peace to the war torn regions of Africa, it remains to be seen whether Kimberly was instrumental in  reducing tensions in the area.   

However, what it did do was reduce the supply of cheap rough in the secondary markets which allowed both private and state controlled mine owners in Africa, Russia, Australia, and Canada, to either maintain or increase rough diamond prices.  It’s little wonder both sovereign governments and mine owners alike supported the Kimberly process.  

Implications: On the one hand, a Mervyns' bankruptcy could be just another closure of a region department store chain typical of 30 years of store consolidation in the US. On the other, it could be an opportunity to revive a regional name in a market that is quickly rejecting 'cookie cutter' retailing that offers poor service, merchandise sameness, and mediocre quality.

Analysis: According to the NY Post, Mervyns’ Department stores could file bankruptcy by the end of July.  If true, Mervyns will become another 2008 store closure statistic as shoppers cut spending to conserve cash.  Collectively, Mervyns’ store closures will add to the 7% increase in stores to shutter this year.  The ICSC has predicted that about 144,000 stores will close in 2008, the highest number since about 1994 according to data that is available.

Realistically, a Mervyns bankruptcy shouldn't come as any surprise.  The company has struggled to justify its market position since it was acquired from Target by Sun Capital and Cerberus Capital Management  for about $1.2 billion in 2004.  Probably more a real estate play than a legitimate retail turnaround, a Cerberus spokesperson in the Post article suggested the company “more than doubled its money” through its stake in the real estate company that was Mervyn's landlord.  Meanwhile, Cerberus sold its Mervyns’ stake to Sun Capital in 2007 transaction that was only revealed earlier this week. 
 
In retrospect, Mervyns probably could have been revived if a merchant had been running the business.  After all, the company had always been a niche player in the California market place competing with much bigger and better capitalized competitors.  But merchants didn’t buy the company.  Clearly, Mervyn’s success was more about the real estate bubble in the Southwest than it was brilliant positioning and merchandising. 

In deed, had Mervyns positioned itself somewhere other than in the bad land between the discount department store like Target and the high end such as Nordstrom, the company may have be benefited from today's economic slow down.  But its didn't and after all, the risk in changing retail position wasn't necessary for investors to make money selling off the Mervyn's properties.  

Now with the economy slowing, Mervyns has to change or close.  Unfortunately, at a time when retail sameness grips the market, Mervyns could down size and return to its roots, if only there was a merchant to run the business and an investor that had confidence in retails future. 

Contrary to popular 20th century retailing theory, the future doesn’t necessarily belong to the national chains .  In fact the “wheel of retailing” is already rolling along heading toward, smaller, more discriminating retail formats that offer something other than the bland, sameness found in every mall across the USA at Penney, Sears, Macys, Kohls, Target, and Wal-Mart. 

Implications: With consumers more uncertain than ever about just how much, what, and where they will buy back-to-school products, middle market retailers need to rethink their offer now and in the future.  Here's why

Analysis: Just what July retail sales growth will be is any bodies guess.  Overall June’s sales figures were better than expected.  But most of the department store sales growth came from Wal-Mart.  Excluding their gain, June sales were significantly below the core inflation rate.  That means average department store unit sales declined for June as average sales prices lagged inflation driven price increases.  

That’s bad performance regardless of the spin pundits put on it, plain and simple. Whether July will be any better will depend on strength of back-to-school sales.  However, unlike in years past were there was a strong expectation of solid sales growth for B-T-S products such as branded apparel, computers, and sundry  school items, retailers are less optimistic this year.   

The fact is consumers are sending mixed messages about their back-to-school shopping plans.  One characteristically optimistic survey by the National Retail Federation predicted B-T-S sales would increase about a 5.5% this year.  In this instance 8,000 shoppers said they would spend about $594 this year versus about $563 last year, with electronics sales growing the most.   When compared to June sales, that projected growth is about 34% higher than the average department store increase of 4.3% in June.  But it is a whopping 190% more than June’s retail department store’s sales gain without Wal-Mart’s numbers.   

However, other research isn’t so optimistic.  One survey by Deloitte LLP “found 71% of consumers planned to spend almost $100 on average less on back-to-school items this year”.  Using NRF averages and combining the two surveys, the remaining 29% of back-to-school shoppers will have to spend an average of $912 per person or 62% higher than last year’s average sale to achieve the NRF’s projected B-T-S average sale numbers.   Regrettably, numbers are all over the place.  It remains to be seen if retailers really have a handle on just where sales are going now.  Last years sales mix, units sold, and average sale prices are virtually meaningless for forecasting purposes.  That means demand forecasting models are generating random numbers as much as anything else.  That’s especially true for slow turn, higher priced products typical of luxury items such as national name brand gifts, jewelry, and watches.  

If the NRF numbers are correct and Wal-Mart’s growth rate continues, July B-T-S sales won’t be the big  bounce for non-discount department stores this year as in the past.  That leaves August for retailers like J.C. Penney and Macys to catch up.  But that’s problematic too.  In fact, it’s hard to write a creditable storey why discounters like Target and Wal-Mart won’t run the table on traditional department stores during the fourth quarter this year and in the foreseeable future, unless middle market retailers change.    

For 2009 mid-market retailers will need to rethink their entire offer if the macroeconomics dosn't change dramatically.  By that I don’t mean that price increases flatten out, but decline significantly  It’s a mistake for retailers to think that the demand will rebound and buying behavior return to pre-slowdown patterns if transportation, food, utility, health care, and shelter costs remain at their current levels long enough.  Under that scenario, demand will be stagnant as most of consumer’s disposable income will continue to be used for necessities.  That’s even more true if wage growth remains flat and average income declines as the population continues to grow.    

Some analysts will disagree.  Their argument is that disposable income will increase as alternative energy sources come online and consumers switch to more fuel efficient cars.  But alternative energy isn’t cheaper, only less subject to foreign manipulation.  Moreover, average gasoline engine efficiency would have to double to reduce net gasoline expenditures to 2005 levels.  That’s probably not going happen for decades, if ever.  Regardless, whatever the savings, much of it will be used to offset increased technology costs and loses from the disposal of existing trucks and SUV at depressed market prices.   

Another reason retailers need to rethinking their product offer is it's uncertain politicians and special interest groups will ever allow energy prices to revert to their historic levels.  If true, consumers will continue to be faced with higher costs because of new energy taxes, even if commodity prices decline.  In effect, this years back-to-school sales, less the bump from rebate checks, may mark the norm for the future, not the exception and retailers might as well get a head of the curve now. 

Implications: As the leading membership club retailer, Costco looked to benefit as consumers looked for better deals to stretch inflation taxed paychecks.  Now declining margins from gasoline sales, higher operating costs, and increased product costs, may make the retailers fee based profit model irrelevant. 

Analysis: Costco surprised traders, warning that “4th quarter earnings would be well below analysts expectations”.  Until recently, Costco has benefited from the current economic slowdown as members bought more from the warehouse clubs to offset higher costs from inflation.  Now it seems that inflation is also eroding Costco’s profits as it fails to raise prices to offset higher product costs.  

According to Costco, earnings have been especially hurt by the escalating cost of gasoline at club stores operating gas station.  Once a profit center, gasoline reseller profits across the country have been marginalized as oil prices have more than doubled in the last 12 months.  The fact is gasoline resellers have little competitive advantage in gasoline distribution system where most of the profit is made at the wellhead.  

Higher food cost has also cut into Costco’s margins.  Evidently, the company has absorbed more of the cost increase than it passed along to its members; eroding margins in the process.  Why Costco would need to absorb that much of the increased food costs isn’t clear.  The original rationale behind the membership club profit model was that member fees in combination with low product margins gave the format a competitive advantage in the market.   

According to the Wall Street Journal, Costco’s CEO James Sinegal said company markups on non-branded products were about 14%, while branded items were marked up approximately 15%.  That was several years ago.  Now, if Costco has to absorb current cost increases to remain competitive, either the company’s ‘low’ sell prices aren’t really that low today or the fee income is inadequate.   

Given the consumer’s focus on saving, it would be logical to think club membership fees would be growing and new membership would be driving incremental sales.  However, if membership is either flat or declining, existing fee income may be insufficient to cover higher operating costs.  Either way, current consumer buying behavior and the changes in the company’s structure brings the long term viability of the profit model in to question.  

If Costco is having earnings problems, investors have to wonder what is happening to profit margins at Sam’s Warehouse Club.  A division of Wal-Mart, Sam’s operates on a similar membership profit model as Costco. While Sam’s has more outlets than Costco, it does less business.  In part the reason is Sam’s caters to a less affluent customer and sells lower price point products.  The question for Wal-Mart investors is whether Sam’s will experience the same margin problems as Costco.  

While Wal-Mart stores have clearly benefited from the bad economy, Sam’s makes up about 12%-13% of Wal-Mart’s total sales.  A material decline in Sam’s stores profitability could erase a good part of Wal-Mart’s new found earnings as gasoline, food, and other operating cost continue to increase during the 4th calendar quarter of 2008.

Implications: Despite out performing the Dow, S & P, and the Nasdaq, short sellers are betting Zale's share price to significantly decline.  Here's why.

Analysis: Zale stock has fallen from a high of $22.35 on March 24th to a low of $16.06 on July 11th.  Currently trading around $19.80, the stock is held by approximately 238 funds and institutions.  Most recently some firms have begun to liquidate their positions in the company.  For instance, Huntington National Bank “dumped” their entire 35,200 share position in Zale, while larger investors like Cooke and Bieler Lp sold about 9.9% of their holdings or 347,459 shares.  All told, the number of funds selling Zale stock out number buyers by about 2 to 1.  Still, Zale’s share price has outperformed all of the major indexes over the last six months.  Since January 2nd, Zale has increased 38.1% while the S & P, NASDAQ, and Dow have declined (12.9%), (12.6%), and (12.2%).  Similarly, Zale’s stock price has outperformed all its public jewelry competition.  The question is why?   

Most of the stock’s price performance can be traced to the company’s huge stock buy backs over the last 12 months.  Since August 2008, Zale has repurchased $350 million of its stock or about 28% of the outstanding shares. That reverse dilution has had the effect of maintaining share price, despite the company’s operating loses. But that’s only part of the story.  The other, Zale’s Enterprise Value has actually declined about (20.4%) or about $357 million when comparing stock prices and balance sheets as of 2007 YE and 3rd quarter 2008.   

In effect, management’s aggressive buy backs have been a slight of hand.  Using reverse dilution, Zale’s share prices have declined only (2.4%) for the first three quarters of FY 2008 as the DJI dropped by about (4.0%)  That looks pretty good to short term traders seeking to maximize quarterly returns in a volatile market.  Even better, Zale has continued to outperform the market during its 4th fiscal quarter as the company’s per share price declined (7.7%), while the Dow decreased nearly (14.0%).  

However, a growing number of traders think Zale’s shares are over priced.  According to ShortSqueeze.com more than 46% of its stock float has been ‘sold short’; meaning a lot of speculators are betting the stock is going to decline.  Just what’s driving these short sales isn’t certain.  Part of the reason may be pure speculation, another, the economy.  With the dollar declining and energy prices escalating, the consequence of “real” inflation has been reduced spending in combination with changes in consumer’s shopping behavior.  That’s bad news for middle market jewelers like Kay (Signet Group Plc) and even more so for Zale (Zale Corporation) which was bleeding market share long before the economy softened.  But, I suspect the real reason traders are shorting Zale stock to such a degree is their overwhelming belief that the huge buy backs are at an end and with no top-line sales turn around insight, the stock price has no place to go but down as future loses increase.  

What Zale’s final numbers for FY 2008 will be is anybodies guess.  Analysts estimate the company will lose ($0.58) for the 4th quarter ending in July for a cumulative lose of ($0.32) for the fiscal year.  But, those numbers could be better depending on the success of the company’s up to 70% liquidation sale.  But better numbers won’t mean Zale’s operations are improving; at least not in this situation.  The fact is the company’s current off-price strategy isn’t sustainable and what’s worse future sales will suffer significantly as the company returns to regular margins in 2009. 

Nevertheless, the industry continues to estimate FY 2009 earnings will be about $0.92 per share.  That expectation of a 200% increase in earnings per share may be another reason why the stock’s price has held up so well.  But realistically, it’s hard to find a compelling story why the company’s performance will improve anywhere close to that figure and that’s the short sellers play.  

Unfortunately, what ever the story, it won’t be the first time shareholders will have heard it.  Regrettably, Zale’s performance has been a disappointment for some time.  Since 2003 Zale has significantly under performed the market in spite of countless plans by the board to turn it around.  During that time there has been constant management change in the company; including three Chairman, five CEO’s, one COO, 3 CFO’s and countless division presidents, operations officers, general merchandise managers, and buyers.  The only other company in the industry that has experienced that degree of senior management change in such a short period of time is Whitehall Jewelers and it’s currently operating in bankruptcy.  

Now a hollow shell of what was once called [America’s] Diamond Store, the companies strategy has been reduced to closing stores, selling divisions, consolidating operations, foregoing new store growth, and reducing marketing spend to fund the huge stock buy backs, while increasing company debt.  Most of that strategy has been at the encouragement of Richard Breeden, Chairman of the hedge fund, Breeden Capital, which owns about 22.8% of Zale’s equity.  But, part of the responsibility lay with the company’s new CEO, Neil Goldberg too.  

When Goldberg came to Zale, he was quoted as saying the pricing structure was too complicated, something he would change.  Now the company’s pricing strategy is much simpler; that is, up to 70% off.  At least that has been the message to consumers for the last 7 months.  Granted, his pricing strategy has enabled the company to liquidate about $100 million in inventory that has funded the stock buy backs, but at what cost to the Zale and Gordon consumer franchise. 

While it’s true consumers like jewelry sales, recent research suggests they view jewelry store names as the primary brand, not the product they sell.  If true, Goldberg’s 213 day liquidation sale probably has done more damage to the Zale and Gordon brand names than all the company’s mistakes combined in the last half decade. Then, there’s the innumerable product and merchandising mix problems that Goldberg inherited, but by all the evidence to date, problems he neither has the knowledge nor the working capital to fix.  Lastly, there are the strategic issues of off mall retailing and e-commerce jewelry marketing, to a lesser degree, that he isn’t addressing at all.  

Five years ago, the company could take the position that some of those issues weren’t immediate problems.  That may have been true then, but not now.  For instance, mall jewelers have become isolated from a large segment of consumers.  Meanwhile, mall occupancy costs have increased, while foot fall has declined.  Many mall jewelers are spending almost twice as much, as a percentage of sales, on advertising than they were 15 years ago to generate less traffic.  All the while occupancy costs have increased and merchandise gross margins on strategic products like diamonds have declined.  

Zale’s largest competitor Signet Group has been increasing selling space at more than 10% per year, much of it off mall.  Concepts like Signet’s Jared, Galleria of Jewelers will contribute more than $500 million in sales to Signet’s top line from customers that will probably never step foot in a Zale owned jewelry store, especially now that they have divested their high end, luxury jewelry division.  

Most recently, the company elected Yuval Braveman, a specialist in rough and polished diamonds to its Board of Directors.  That suggests a company priority is to strengthen its diamond resourcing capability.  But with cutting and polishing margins collapsing, the only profit centers left in the pipeline are at the mines and in retail.  Reverse integration isn’t a solution for Zale’s margin problems and even if it were, the added net margin benefit wouldn’t be sufficient to offset the company’s chronic decline in sales.    

All told Zale stock has offered the best of things to short term traders looking to beat current market trends and it now looks like it has become a ‘favorite son’ of short sale speculators.  What it isn’t, is the stock of a company  teetering on sustainable growth.  While chairman, John Lowe continues to insist the board wants to turn the company around, it’s now clear that he is either posturing, hoping a buyer will save him from the fate of his predecessors or he (the board) doesn’t know how to fix it.  Either way, it’s sad because with both the industry and the customer is in a state of change, the here and now may be a once in a century opportunity for Zale to reinvent itself and just may be the industry too.      

Implications: The courts decision on whether consignment goods will be a part of the Whitehall liquidation sale could make vendor financing for Finlay Enterprises and many mid-sized jewelry more difficult, if not impossible this fall. 

Analysis: Whitehall vendors that supplied about $63 million in consignment goods have more jeopardy now that Judge Gross ruled that the company could include memo goods in the sale saying "that Whitehall is proceeding with the sale at their own risk with the consignment good uncertainty."  According to court papers, the Judge deferred the decision until July 24th.  

However, with historical precedent against them and the fact that UCC filings are classic example of ‘form over substance’, don’t be surprised if consignment vendors are classed as general creditors.   Meanwhile, secured creditors will be even more insistent on including consignment merchandise in the sale now that the Judge denied stalking horse fees of about $940 million.  This means there will be no minimum bid against which competitive buyers, if any, will have to bid against.   

The end result will probably be a sale of all Whitehall inventory in order to maximize the amount cash available to all classes of creditors through the liquidation.  Some may contend that won’t maximize the firms' value but it will maximize the amount of cash proceeds from the sale, probably the court’s first priority in the event a cash buyer doesn’t step forward. 

After the sale, the creditors committee will have to submit a plan to the court on how the proceeds should be distributed.  But it’s pretty clear that secured bank debt and debentures owned to hedge fund owner/investors will have first priority.  The remainder, if any, will be distributed to the unsecured creditors.   

Consignment goods creditors could be set up as a separate preferential class if the unsecured creditors committee agreed.  That would provide a procedural precedent that could help protect consignment vendors going forward.  However, it’s problematic whether current suppliers would ever agree to such an idealistic compromise.  

What is certain is that suppliers will have to rethink their plans to extend both credit and merchandise on consignment to many jewelry retailers this fall.  Clearly it isn’t business as usual and there are more large and mid-sized jewelry operators that will have liquidity problems in January 2009.  For instance, Finlay Enterprises.  With more owners’ investment secured by offsetting secured debt, UCC vulnerable in a pure liquidation, and large chains with liquidity problems, vendors have more risk than ever.  

Implications: As Finlay is delisted from the Nasdaq and its bond rating lowered to that of "Junk", Macy's and Zale investors need to consider the consequences of a Finlay bankruptcy.  Here's why

Analysis: Finlay Enterprises, Inc announced its stock would be sold on the Over the Counter Exchange (OTC) after it is delisted from the Nasdaq on July 11, 2008.  Finlay had been notified earlier that the company was not in compliance with certain minimum listing requirements to continue trading on the Nasdaq Exchange.

The delisting is just one of several events that have raised questions about the department store lease jewelry operator’s future.  Earlier Standard and Poor’s had reduced the company’s credit rating from “B” to “CCC” after Finlay reported weak 1st quarter sales.  The “CCC” rating means Finlay’s debt is valued as “Junk” in the bond market.  In particular, the rating means that Finlay’s future liquidity depends in large part on a “favorable” business environment; a description only the most optimistic trader would use to describe today’s economy.  

To say Finlay’s future is “uncertain” would be an understatement.  Its department store jewelry business has been in decline for years both in terms of the number of departments and the average sales per department.  The company has sought to offset that decline by acquiring higher end, specialty retail jewelry businesses such as Carlisle and Congress Jewelers.  Most recently, the company bought about 70 Bailey Banks and Biddle stores from Zale Corporation for about $200 million.  That transaction significantly added to their leverage which was already about the highest in the industry.  It also increased Finlay’s working capital requirements at a time the company was about to lose about 150 less cash intensive, jewelry departments.   

Some analysts believe the company has “bet the farm” on the turn around of the BB & B stores which were under performers under Zale’s management.  Relatively speaking, the high end luxury jewelry market has continued to grow despite the poor economy.  The problem is BB & B is really a turn around business itself.  Whether Congress and Carlisle can throw off enough cash to mitigate soft department store jewelry sales and fund BB & B turn around requirements is problematic.  

Clearly the company will need supplier financing this fall if it is to buy the inventory necessary to support Christmas sales in the 4th calendar quarter.  However, vendors may be reluctant to provide unsecured credit to Finlay this year after both Friedman and Whitehall Jewelers filled bankruptcy in the first half of 2008.  That will be particularly true if vendors lose their right to consignment merchandise because of unperfected UCCs in the case of the Whitehall default.    

Should Finlay be unable to secure sufficient vendor support, it would have no other choice than file for protection from its creditors.  That would start a chain reaction which would have significant consequences for the department store industry, especially Macy’s, and specialty jewelry retailers, most especially Zale Corporation.  Macy’s would be most affected of all the department stores from a sales and inventory point of view.  Whether the company would buy the fixtures and inventory and take the business in-house, look to start fresh with new assortments, or out source the business again remains to be seen.  

On the other hand, Zale Corporation will be “on the hook” for Bailey, Banks, and Biddle store lease payments that it guaranteed as apart of the luxury chains sale to Finlay in November 2007.  According Zale’s latest 10Q, the future value of that contingent liability is about $85 million.  Unfortunately that liability is looking less contingent and more certain as Finlay’s business outlook worsens.

In retrospect, Zale Board’s decision to guarantee those leases in the event of a Finlay default has to be one of the most imprudent business decisions in the company’s history. While the guarantee may have facilitated the sale of its high-end division to Finlay, it reduced the future enterprise value of Zale by many times more than the value it gained from BB & B's sale.  

Implications: According to unnamed sources, Gitanjali Gems wants to acquire Whitehall Jewelers.  Gitanjali, a nascent billion dollar Indian jewelry manufacturer, says it's willing to do an $80 million to $92 million deal to expand its presence in the US. 

Analysis: According to Reuters UK, Gitanjali Gems (GTGM:BO) plans to buy Whitehall Jewelers.  In the report, G.K. Nair was quoted as saying that “[Gitanjali is]…looking to expand” its operations in the US.  Presently, Gitanjali owns 97% of Samuels Jewelers, a 97 store jewelry chain with stores in about 18 states.  The Indian based jewelry company also owns 100% of Rogers Jewelers, a chain of 47 mall based jewelry stores situated principally in the mid-western US.

Gitanjali Gems was a medium sized diamond manufacturer that specialized in buying, cutting, and polishing rough diamonds in India until about two years ago.  Since then the company has embarked on a global strategy to vertically integrate its operation from polished diamond production, jewelry manufacturing, and retailing. 

Today, the company operates 2 loose diamond facilities, 5 jewelry factories that supply finished goods to 112 distributors and 1,246 retail outlets in India and the US.  In addition, the company now has or is the process of developing 6 SEZ (special economic zones) totaling approximately 130,000 square feet.  These SEZ allow the company to minimize handling costs of imported raw material and stocks for both its manufacturing and retail operations in India.  

Only about 3% of all retailing in India is classified as organized.  The majority is family owned, however, that is changing.  Gitanjali has acquired about 11 national jewelry and gift brands which it’s using to consolidate new retail jewelry growth in India.  It also has plans to implement a similar strategy in the US, hence its interest in Whitehall Jewelers.  According to Gitanjali’s Annual Report the company “expects Samuels [and Rogers] to source a significant portion of their jewellery products from Gitanjali.”  If the company was able to acquire Whitehall Jewelers 375 stores, it would likely be the principal diamond supplier to about 518 mall based jewelry stores with a annual turnover of about $475 million.

However, it remains to be seen whether the company can strike a deal with the creditors to buy Whitehall.  Longer term, it’s even more problematic if the Gitanjali’s product breadth is sufficiently broad enough to support 518 jewelry stores in the US marketplace.  According to unnamed Reuters’ sources, Gitanjali's deal with Whitehall is between 3.5 billion and 4.0 billion rupees.  That’s $80.85 million to $92.45 million at current exchange rates.  The question is whether all classes of creditors would be better off liquidating the company.   

According to court papers the company had $207 million in assets and about $185.4 million in debt.  The Gitanjali deal would probably mean unsecured creditors would get pennies on the dollar while secured creditors recouped most of their investment.  With Gitanjali the likely beneficiary of Whitehall’s future purchases, trade creditors have little incentive to agree to the deal and would get more if the company was simply liquidated.  Another possibility would be to liquidate the existing inventory and sell the Whitehall name and fixed assets to Gitanjali.  How much irreparable damage a 90 to 120 day ‘Up to 70% Off’ liquidation sale would do the Whitehall and Lundstrom trade names is an open question.

If Gitanjali is able to buy the stores, it will represent the beginning of a new era in the US jewelry industry or perhaps a return to an earlier time for those that can remember that far back.  Zale pioneered vertical integration as it grew to number one status in the 1970’s.  Then Zale had its own DTC rough diamond site and operated a loose diamond operation in Tel Aviv.  While it didn’t have its own manufacturing factory, it did have its own assembly facilities where it set and finished diamonds and castings purchased from domestic suppliers.  The buying arrangement maximized Zale profitability in the beginning, however, the company found vertical integration ultimately lead to poorer retail assortments as in-house manufacturing conflicted with the stores product and marketing  programs.  How Gitanjali expects to avoid the same pitfalls isn’t clear as is how the company plans to mitigate fall out from its current retail customers as it grows to one their largest competitors.

On paper, Gitanjali appears an overnight success.  The company’s sales have grown to more than a $1 billion dollars in the last 24 months.  However, just how sustainable that growth is remains to be seen.  By US financial standards, it operating margins are very thin, meaning the company doesn’t have a lot of room for mistakes. Up to now much of its new growth has come from the emerging Indian consumer market which is expanding rapidly and is very open to retail change. 

However, the acquisition of Whitehall and the subsequent operation of over 500 mall based retail jewelry stores will shift both the opportunity and the consequences of failure to the US market.  Positioned in America’s over stores, highly competitive, middle-market, it will take more than Indian brands and skillful manufacturing to make these stores financially successful. 

The fact is the mid-market jewelry business in the US today is a zero-sum game and the question remains if the company has the merchandising finesse and financial resources to ‘profitably’ steal a half billion in jewelry business from the likes of Kay, Zale, Helzberg, Fred Meyer, and discounters like Wal-Mart and grow in India too. 

Implications: In spite of nearly a decade of jewelry product brand advertising, not one brand makes the top 10 list according to the latest research from Harrison Group and the JCK.  Here's how consumers think about jewelry brands.

Analysis: Investors in large retail jewelers should welcome these latest research findings.  According to a recent JCK-Harrison study, most jewelry buyers think of prominent jewelry trade names like Zale and Kay as brands almost to the exclusion of all designer and manufacturer’s brand names.  Despite millions of dollars in advertising since the DTC inaugurated its supplier of choice program which “encouraged” manufacturers and retailers alike to develop jewelry product brands, virtually none have gained any awareness with consumers.  

Ironically, the study found that Zale was the most recognized brand, followed by its larger competitor Kay in unaided recall.  Zale has lost market share to Kay Jewelers since about 1994, when Signet Group decided to take the name national.  Presently, Zale is losing money, closing stores, consolidating functions, selling off divisions, and increasing debt to fund stock buy backs.  The significance isn’t that Zale remains number one, but that in just over a decade, Kay Jewelers recognition has gone from near obscurity as a regional jewelry chain to second most recognized jewelry brand in America.  If true, it’s only a matter of time until Kay edges Zale out for the number one spot as Zale reduces marketing spend and closes more stores.

Other trade names that were also mentioned as brands were Tiffany and Cartier as were two watch manufacturers Rolex and Seiko.  Rolex and Tiffany's recognition was predictable because both names are widely known as symbols of wealth and status in the US and overseas.  The same is true for Cartier, but to a lesser degree as its #8 position demonstrated. 

Seiko brand gained traction in the 1960’s as US veterans brought Seiko mechanical watches back from the Vietnam War.  Later, under Pliskin and Morea’s leadership, Seiko replaced Bulova as the #1 brand in the US with quartz watch technology.  Eventually, Bulova ended up on the back walls of fine jewelers as Seiko brand gained prime showcase position.  Eventually, Bulova was sold to the Lowes Corporation as much for its real estate holdings as it was for brand value.   

In spite of Seiko high brand awareness, Citizen now out sells Seiko brand today.  In fact, Citizen is the leading mid market brand in America, but didn't make the top ten brand list.  Interestingly, Citizen bought Bulova brand in the spring of 2008, a move that will increase its manufacturing leverage and probably increase Bulova distribution in the market; if Larry Grunstein, President of Citizen. USA has anything to do with it.  However, despite Citizen's dominance in the US market, it didn’t show up on either the aided or unaided list of top ten jewelry brands.  That could because of methodology or suggests consumer awareness has less to do with brand selection at the store level than most marketing specialists would like to admit.

Clearly, researchers expected some of the thousand or so designers, jewelry manufacturer’s and retail jewelry product brand names would have gained a degree of consumer recognition in the last decade. Apparently that hasn’t happened.  According to the research results, names like “David Yurman, Roberto Coin, Scott Kay, Hearts On Fire, and popular names like Mikimoto and ArtCarved didn't make the top 10 at all.” 

Realistically, that isn’t surprising.  Anyone familiar with brand management knows it can take over $50 million in advertising in a single year to establish a brand in the US market and equal amounts over several years to maintain and grow a brand’s awareness.  Even with that level of marketing support, brands still fail because fuzzy differentiation and poor distribution. 

With the exception of large companies like Zale, Signet, Tiffany, Rolex, Cartier, and DeBeers, few, if any, designers or jewelry manufacturers have the capital resources to mount such a costly advertising campaign.  Moreover, most products aren’t sufficiently differentiated to gain awareness in the US market beyond a select few niche consumer groups, as these results demonstrate. 

Just what DeBeers had in mind when they started their industry branding initiatives in 2001 has never been clear to me.  But one thing is certain, the result has been a proliferation of obscure, mostly irrelevant names that clutter showcases with a menagerie signs, logos, and colors that have no meaning to consumers at all.  Collectively, jewelry retailers have probably invested in excess of $100 million in advertising over the last 6 years to promote these names, often at the expense of their own retail store name.  That's the opposite of how customers think; if this research is correct.  Meanwhile, in the midst of all this brand confusion, DeBeers has managed to position its new retail brand in the ‘top 5’ with fewer than seven stores operating in the US today. 

Lastly, this research emphasizes the power local and regional jewelry names continue to have with consumers.  According the research, “57% of the respondents wrote the name of a local independent jeweler, regional chain, Web site, or brand [when asked], And what other jewelry brands or companies come to your mind next?”  That suggests smaller jewelry businesses should position their store name as a leading jewelry brand in their community or region as opposed to a jeweler selling specific jewelry brands.   The fact is most consumers don’t know these brands, but they do know the names of “Their Jeweler”.  

Evidently, the store as a brand is what's “top of mind” from the consumers point of view.  Incidentally, that's how it used to be and this research seems to say consumer thinking really hasn’t changed despite all the brand proliferation.  However, along the way, it seems a lot of retail jewelers have lost sight of that fact; something they need to rediscover.   Store name awareness as a leading jewelry brand is a powerful competitive advantage many small jewelers have failed to exploit.  Now with second tier chains like Friedman’s and Whitehall going out of business and large chains like Zale in financial distress, independents and small chains  have a unique opportunity to take the initiative and reconnect with their customers. 

Implications: New Kmart formats are too little and too late to save the giant retailer.  Here's why Sears Holdings'  luck has probably run out.

Analysis: Evidently Sears Holding is testing at least one new format for its “Big K” stores.  That’s the other name for Kmart, depending on what part of the US you live in.  Kmart’s sales and profit declines have recently accelerated despite the economic slow down that has seen its competitors sales grow substantially.  Now, as Wal-Mart and a host of other discounters gain even more market share at Kmart’s expense, SHLD is testing new formats.   

According to company spokespeople, Chairman Eddy Lampert has been reluctant to invest in a new store format for either Sears or Kmart without a proven success record.  Just how much encouragement he will get from two stores trading covertly in Rockford, IL isn’t clear.  The issue is probably more one of management insecurity, than a determination to get the format right.   

If hedge fund owner and Sear Holding’s Chairman thinks he can develop a new ‘big box’ concept in a vacuum he is likely to be wrong, again.  What he needs is visibility, especially consumer visibility, and a lot of it.  He also needs a willingness to listen to what customers and store managers tell him. Unfortunately, listening hasn’t been on of the Chairman’s strengths.   

Just what he has in mind, remains to be seen; customers that have shopped the store report wider isles and less product density.  If that’s true an upscale Kmart may be the plan.  But isn’t that what Sears Roebuck is today.  In effect, Lampert tried to move Sears from its specialty branded roots to compete with the likes of both Wal-Mart and Target and ‘killed’ what was left of Sears in the process.  

Now as Sears crumbles, his organization refocuses its attention on Kmart.  That isn’t surprising.  It seems to fit his personality.  He has made lot of money by doing the ‘big’ deal.  Strategic incrementalism isn’t the way he thinks.  That could be a good thing, if he were a visionary retailer, but he isn’t.  It could also be a good thing, if he knew how to recruit the best retail talent and listened to them, but he won’t.  That leaves about half the shareholders with disintegrating $50 billion business waiting for a ‘big’ solution to make everything all right.  

Specialists say four things are essential for a turn around to be successful.  One: a base of customers that is sufficiently large to support the core business.  Two: a way to make a profit that is defendable.  Three: adequate cash to support the business during the turn around.  Last:  luck and lots of it.  Sadly, management’s indecision, combined with their ‘big’ deal operating style drove customers away with mediocre product offers while the board squandered its cash on overpriced stock buybacks.  Now, as the economy slows and their largest competitors strengthen, management has probably run out of luck too.   

Implications: Whitehall Jewelers entry into jewelry's middle market tempted fate.   Now, the question is not if, but when the company will disappear and how much of the trade it will take with it.  Here's one view of how the situation will evolve and what's next for the industry. 

Analysis: Whitehall Jewelers Inc. said it was considering bankruptcy protection less than eight weeks after buying 78 stores from Friedman Jewelers for about $14 million.  At that time Friedman was in the process of closing about 400 stores as it ceased operations.  Now, it looks like Whitehall could follow the same path.  According to the company, it has defaulted on at least two obligations to make interim payments on debt owed to Fabrikant Receivables LLC and Rosy Blue Inc.  If Whitehall can’t negotiate new terms with these creditors, it will trigger a cross default in which the company’s $65 million in senior debt will become immediately due and payable.   

However, realistically, Whitehall’s financial problems are significantly greater than just renegotiating new terms with two creditors.  The company has said that its current operating cash flow isn’t sufficient to meet its future obligations beyond the end of June 2008.  That means the company will be technically bankrupt in 8 business days.  Even if it can make some accommodation with debt holders, it’s unlikely trade creditors will provide the company with sufficient credit to buy merchandise for the all important Christmas trading season.  

Historically, jewelry and watch suppliers have been supportive of jewelry retailers in financial jeopardy.  Then many of the businesses were either privately owned or family managed with social and economic ties to the industry.  The business wasn’t just an investment, but the only means families had to earn a living.  Losses not only wiped out the families life savings, but often destroyed the future of the next generation too.  That was a big incentive to focus on running the business, avoid risk, and pay the trade.  But things have changed.  

Today, many of the larger jewelry chains are owned venture capital firms or hedge funds.  As such they’re often financed by debt that is structured to look like equity.  The fact is, in the event of failure, the company’s senior debt holders (defacto equity owners) get most of their investment back, often at the expense of trade and general creditors.  Now, jewelry and watch suppliers recognize the industry has changed and are refusing to take big restructuring loses while capital owners walk away with their original investment.  

Friedman Jewelers is a good example of this trend.  Owed about $9 million, Rosy Blue Inc and three other large diamond suppliers petitioned the court to put Friedman’s into Chapter 7 fearing the company would be ultimately reorganized benefiting equity owners (senior debt holders) at the expense of trade creditors for the second time in as many years.  The company later filled for Chapter 11 protection only to be liquidated about two months later when an auction failed to achieve a sale price that was mutually satisfactory to senior debt holders, general creditors, and the trade alike.  Partial transcripts of the auction proceedings suggest trade creditor’s fears were justified.  

If the Friedman’s bankruptcy is the measure, Whitehall probably won’t be restructured, not if it means the trade won’t get paid.  In addition, even if the company can arrange DIP financing that would secure future trade payables, most firms can’t afford a substantial loss in today’s economy even if it may means more business tomorrow, which is a big if.  That’s especially true, when the same people that ‘stuck it to them’, own and manage the reorganized business.

Second, one of the consequences of venture capital and hedge fund ownership has been the use of non-jewelry executives to operate these businesses.  Typically associates of the capital owners, these operators have been competent financial managers, sometimes general purpose retailers, but seldom experienced jewelry retailers and that’s becoming a ‘red flag’ to the trade; especially in a reorganization. Recent business history is replete with the failures of jewelry businesses led by general retail and financially trained managers without an in depth knowledge of jewelry retailing.  Yet, in spite of their dismal track record, mangers with these skill sets are most often sought out to turn around these distressed businesses.  Friedman was certainly one such example, indirectly, so is Whitehall.  While, it remains to be seen, history will probably point to Zale’s(NYSE:ZLC) demise as the consequence of repeatedly changing general retail management paradigms applied to intensely specialized jewelry retail problems.  Nonetheless, for what ever their reasons, jewelry trade creditors have become much less willing to buy into non-jewelry executive sales pitches especially the second time around. 

The real question for Whitehall creditors and prospective investors is: Does the business have an economic reason to continue?  Originally positioned as higher end jewelry stores selling better diamond rings and jewelry, its offer was later amended to include more luxury jewelry brands.  However, that strategy was severely limited by the stores small size, as well as, the large number of stores.  At a critical turning point, the company’s new management had several choices.  One, they could reduce the number of stores, simplify the organization, and focus on developing the higher end luxury market.  Second, they could take the company down market and compete head on with the likes of Zale, Kay and a host of discounters.  Whether because of inexperience, a lack of market knowledge or a combination of both, the company’s new owners chose the middle market alternative.  In hind sight, that probably was Whitehall’s undoing.   

Today, even if management can get creditors to agree to either a temporary financial fix or a permanent restructuring, Whitehall will be operating in jewelry’s highly competitive, middle market that is already over stored.  It’s problematic whether its larger competitor, Zale, will remain viable in this crowed market, much less a vastly smaller, under capitalized jewelry brand, like Whitehall.  So restructuring probably delays the inevitable, especially under current management.  What’s next?  If the company can’t be restructured, it will be either sold or liquidated which begs the question of who would want to buy it?  

Again, if Friedman’s is the model, it will be a hard sell.  Whitehall was the only serious bidder for Friedman’s stores and then only 78 or the nearly 500 total locations that were available were bought.  Whitehall’s locations are better quality, but only average about 900 square feet.  Accordingly, most of the legacy stores are too small for all but a few specialty businesses.  If the business can’t be sold as either an ongoing jewelry concern or to an existing retailer, the future lease values will revert to the developers through the bankruptcy process.  That will leave creditors about $150 million of jewelry and watch inventory at cost to recoup nearly $158 million in liabilities based on the February 2, 2008 balance sheet, excluding the $14 million the company paid for the Friedman stores.  

How long could all this take?  Not long.  The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 changed the time line for both individual and company bankruptcies.  Unlike in days past where the process could take years, Whitehall stores could be either sold or closed and the inventory liquidated by the end of summer.   

Where does this leave the industry?  A lot smaller, but not the way many pundits thought.  Most analysts believed independents and small chains would be losers as larger chains stole their market share.  But that isn’t what’s happening.  Instead, mid-sized chains are the losers because they are too large to be close to their customers and two small to leverage their higher operating costs.  Regardless, for what ever the reasons, if Whitehall closes its doors, about 800 specialty retail jewelry stores will have disappeared in the first three quarters of 2008 if you add Friedman’s liquidation and Zale’s store closures to the total and that could be just the beginning.   

Distressed debt buyers have been circling the Finlay wagon in anticipation of that company’s possible bankruptcy. While Finlay’s jewelry departments will continue to operate even if the lease operator goes out of business, the same can’t be said about Bailey, Banks, and Biddle, Carlyle, or Congress Jewelers. In particular, BB & B’s sixty-nine stores would be vulnerable as creditors look to recoup their liabilities.  As far as the other two luxury chains are concerned, it remains to be seen whether either of the two former family owners would be willing to buy their businesses back in the event of a Finlay bankruptcy.  In any event, that’s another 105 specialty stores that could be in play by the end of the year.  What's next?

Zale will most definitely close more stores after Christmas 2008.  Reverse operating leverage will mean the company’s high fixed costs will quickly begin to erode share holder equity.  Since the end of the 3rd quarter 2007, the company’s enterprise value has declined from approximately $1.39 billion to about $734.4 million or a decrease of (47.4%).  Despite a significant reduction in the number of shares outstanding and a 30% increase in share price, the company market capitalization is only 1.7% higher than it was on January 30th 2008 when it was near a historic low.  That value will most certainly decline further regardless of how much money the company borrows to buy back shares.  Without experienced retail jewelry management to reverse the last five years of mistakes, Zale’s demise is probably inevitable.  But it may take years for the company to unwind.  In the interim, bits and pieces of the company will be sold off; while each successive year’s poorest performing stores will be closed.  Meanwhile the industry will become more polarized leaving one super sized chain, several up market large chains, and a host of highly fragmented small jewelry operations serving local jewelry customers needs.

Implications: Movado Group's earnings declined sharply in the first quarter.  However, the problem may be bigger than a decline in consumer spending in North America.  Here's why.

Analysis: Movado Group recently announced that 1st quarter earnings had dropped 48%.  That’s in stark contrast to other luxury watch makers like Swatch and Richemont both of which has shown continued growth despite the US economic slowdown.  While part of Movado’s performance problem is its dependence of the US market, the company has other issues which may depress earnings in the future.  

For instance, its brands are tired and may be mis-positioned.  Presently, the company depends on its Movado brand for most of its growth.  Unfortunately, this brand’s styling is old.  Movado will point to the fact that many thought that was true in 1983 when North American Watch bought the name.   However, Movado’s classic black dial, gold dot styling has been heavily distributed for twenty-five years now.  In addition, the classic styling has been broadly copied and the name counterfeited which has eroded brand credibility.   

Positioned in the aspirational price range of $500-$1,500, Movado fits between the high end of Japanese brands like Citizen and the luxury brands such as Cartier and Rolex.  Unfortunately, its quality is neither superior to better Asian brands nor as prestigious as the luxury names.  In other word, it looks over priced in today’s market; especially in the US.  

Another positioning issue is Concord.  Now positioned in the “Exclusive” watch category, the brand sells in excess of $10,000.  That’s a big leap for a watch name that was Movado’s equivalent in 1975.  Concord was the first brand the original company North American watch owned.  Then the Concord brand occupied about the same price range as Movado does today.  However, Concord was repositioned to the $1,500 to $10,000 price range as the company began marketing its new Movado brand.  Clearly, Movado was a great success; however, the Concord name never gained that much traction in the luxury market.  Just why management now thinks they can push the name even higher is a mystery.  

Movado continues to lose money in its retailing division.  Composed of both outlet stores and regular Movado retail shops, the division has never been successful.  Earlier, management attributed the problem to critical mass.  The logic was the company had too few stores to be profitable.  That excuse satisfied the market when its wholesale business was stronger, but realistically, its not how the economics of the specialty retail business works.  Granted, occupancy costs for a 100 store chain may be less than for a 20 store business, but not a 35 store operation.  Moreover, as a manufacturer, the company has the gross margin advantage of both a wholesaler and retailer together.  Assuming Movado sales were incremental, logic would dictate the business should be profitable, provided the Movado brand was sufficiently robust to carry over to non-watch products.  Sadly that’s the problem.
 
Whether because of misplaced enthusiasm or just ego, management has ignored the fact that the Movado name has little recognition beyond the Museum watch design.  What ever the brand attributes with respect to aspirational watches are, those qualities haven’t been transferable to diamond rings, gold jewelry, writing instruments, or leather gift and accessory products.   

According to management, about 40% of a current stores inventory is Movado watches with the remaining 60% devoted to Movado’s non-watch products.  That's a reasonable merchandise mix for a luxury retail specialty jewelry store.  However, that presupposes the non-watch product is productive, which is the problem, it isn’t.  Regrettably, that isn’t likely to change.  Historically, few companies have been successful at branding diamond and gold jewelry product.  Transfer branding is often more successful in accessories.  But, it's problematic if the Movado name would ever be successful in the $500 to $2,000 price range which would be necessary to off-set lower sales from diamonds and gold jewelry.

Right now Movado’s future is cloudy.  It needs a new brand to rejuvenate the business.  But in the last twenty years the company has found only two, Concord and Movado.  Now they are tired.  Originally founded as a watch distributor, the company was licensed to sell prestige names like Piaget and Corum. In contrast, today, its licensed brands are Tommy Hilfiger, Hugo Boss, Juicy Couture, Coach, and LaCoste.  But, these brands are less strategic because of their entry level price points and because fashion watches are less relevant to today's connected generation where every cell phone displays the time.  

In addition, the company now faces stronger competition from much larger companies like Richemont and Swatch.  It remains to be seen whether the new generation of Movado management can find a niche where a relative small player, like Movado, can compete against it’s multibillion dollar competitors.    

Implications: As US retailers reduce imports, large companies operating  retailing stores overseas may see international sales growth decline.  Here's why international growth may not be the panacea for retail success.

Analysis: Retail hasn’t been a sector that has got a lot of investor attention lately.  Retail stocks that have caught investor’s eye, though only briefly, have been those with a sizable presence in overseas markets.  Some stocks that come to mind would be Wal-Mart, Costco, Tiffany, GAP, and Movado, just to name a few.  Investor’s rationale seems to be that a weak US dollar will accelerate sales growth overseas which will mitigate sales declines in the US market.  

That’s probably true up to a point.  But realistically, the theory is more about timing than market structure.  Today, consumer markets are linked and while there maybe some lag time, eventually, a declining US economy will negatively affect most overseas economies.  Western European businesses are just now beginning to feel the effects of decreased consumer spending in the US.  In part the issue is reduced demand, but it is also because of increased prices due to the weakness of the US dollar.  Today, US retailers are reducing imports and substituting less expansive American made products instead.  The effects of weak US dollar are not limited to imports only.  Tourism is also declining which is also bad news for most European retailers.  American tourist’s revenue accounts for a significant portion of many overseas retailer sales and European Union’s growth in GNP  

While some large company’s like Wal-Mart and Best Buy have targeted emerging countries for future growth, near term most of these investments will be cash negative.  Moreover, as US demand declines, so will the imports from these countries which will adversely affect domestic demand in places like China and India.  That means retail investments in these countries will take longer to become profitable.  

The fact is none of these emerging countries have the consumer buying power of the US economy.  Unfortunately, all of them, including the European Union, depend on exports to the US for much of their GNP.  So any US monetary policy that deflates the US dollar in the hopes of growing US exports is doomed to failure at the outset today.  Equally doomed is any retail strategy that proffers to grow profitable sales overseas, long term, while consumer spending in the US declines.  

The inconvenient truth is the commercial policies of the US over the last 20 years have had the effect of redistributing economic wealth among the nations of the world.  While US retailers and consumers benefited from these policies when much of industrialized world was fragmented and the remainder where 3rd world economies, economic unification and neo-industrialization is now shifting accumulated US wealth to global economies.  That has significant implications for retailing in the US in terms of the number, size, and profitability of retailers in the sector in the future.

Implications: The jewelry industry is consolidating, but not the way many investors thought.  Here's are some of the winners and losers in this battle for market share.

Analysis: Several years ago, many jewelry industry analysts thought large chains would put many of the independent jewelers out of business.  They thought the industry would follow department store trends and consolidate around a few big players.  Twenty-four months later, it looks like they were right, at least in part.  The industry is consolidating, but the losers aren’t the smaller jewelers, but the large middle market chains.  The fact is small jewelry businesses, that is companies with three or less stores, remain very viable in local and regional markets.  At risk are larger middle market chains where the economies of scale aren’t sufficient to offset higher store operations and buying costs.   

One such example is Friedman Jewelers which liquidated about 400 stores under several trade names earlier this year.  Now it looks like Finaly Enterprises and Whitehall Jewelers are also at risk as the 2008 season evolves.  Add Zale Corporation to the list of struggling chains and its clear the competitive landscape of the industry has already changed and will continue to do so in the far seeable future.  Here’s a brief look at the challenges facing the largest department store jewelry operator,  2nd largest and 4th largest specialty jewelry chains as this season progresses.  

Finlay Enterprizes: Standard & Poor’s downgraded its credit rating for Finely Enterprises and its subsidiaries from B- to CCC.  That change puts Finlay’s long term debt squarely in the middle of  the junk bond classification.  Officially, the rating means the company’s viability depends on a favorable business environment.  Favorable isn’t how most retail analysts would describe today’s business climate.  So Finlay’s equity investors and debt holders have substantial risk that company could have to be restructured in 2008 or early 2009.   

Whether that happens depends in part on trading conditions, but more importantly on short term lenders and trade creditors willingness to support the company’s inventory build up for the 2008 Christmas season.  Already highly leveraged, Finlay borrowed $200 million to buy Bailey Banks and Biddle from Zale Corporation in November 2007.  That acquisition not only increased the company’s debt, but increased the businesses working capital requirements.   

From an investor’s point of view, Finlay’s equity is likely to become even more risky.  According to the  company it received notification from NASDAQ that it’s stock price was below the minimum requirements for continued listing on the exchange.  Currently trading at about $0.61 per share, it's problematic whether the company can convince the market its share valuation should be higher; especially given the current business environment and the reduction in S & P’s credit rating.  If Finlay’s equity is delisted, the company will have no other alternative than offering it on the OTC exchange; limiting liquidity. But Finlay isn’t the only large, public, jewelry company to have problems.    

Whitehall Jewelers: Whitehall Jewelry Holdings is facing continued losses in the face of increased debt.  Whitehall is the 4th largest specialty jewelry company trailing Signet, Zale, and Fred Meyer Jewelers (Kroger).  Whitehall announced increased operating losses for its fourth quarter period ending February 2008.  Most recently, Whitehall purchased 78 jewelry stores from Friedman Jewelers during their Chapter 7 liquidation.  

Now operating 375 stores in about 40 states, Whitehall is a business in transition.  Originally catering to up market diamond, brand conscious consumers, the business was sold after which the new owners repositioned the company’s product offer to the middle of the market.  Now the company competes head on with the likes of Zale, Gordon, and  Kay Jewelers to name just a few.  It’s a crowed marketplace where store differentiation is difficult to achieve.  To make matters worse, most of Whitehall’s stores are physically much smaller than the typical mall jeweler.  That limits assortment breadth, as well as, product and brand variety, a disadvantage that is marginally off set by lower fixed rents.  The company’s acquisition of larger Friedman stores will help improve average store productivity, but has also increased debt and working capital requirements.  

Realistically, whether Whitehall has a future remains to be seen.  The middle market is already over stored  and Whitehall’s offer isn’t that compelling.  Small assortments, average pricing, average quality, and average locations is about the best description of the business.  Add to that, the company is undercapitalized and you have a recipe for failure, especially in this economic environment.  Then there is Zale Corporation.   

Zale Corporation: Zale operates about 2100 locations in the US and Canada under five trade names, the largest of which is Zale Jewelers.  Zale’s sales have been declining for years. Now the company is losing money.  Currently, new management is closing stores, liquidating inventory, reducing costs, cutting marketing and cap-ex spend, all while increasing company debt to buy back stock and prop up the share price.  Frankly, there is no top line turn around insight, at least in the foreseeable future.  If the economy turns around soon, and that’s a big if, company sales may flatten out.  Otherwise there is every expectation the company will continue to perform very poorly.  That leaves Zale Corporations future in question too.  

I think it goes without saying that the company is for sale, but there aren’t any buyers.  Signet Group looked at the company in the summer of 2006, but the parties couldn’t come to an agreement.  Since then Zale has gotten weaker, sold off its luxury division, and centralized operations, buying, and merchandising functions to reduce cost.  Still it’s losing money.  With no buyer insight and facing another weak Christmas season, the company will probably close even more stores in 2009 and look for a buyer of either it’s Gordon stores or Canadian Division.  In either case, this Christmas probably marks the end of Zale as a meaningful competitive threat to other industry players.  

What does all this mean?  For one thing, it looks like Kay (Signet Group Plc) will be the big middle market winner in the US.  If the company implements its plan to move its primarily stock listing to the New York Stock Exchange, US investors could benefit from higher multiples and increased trading liquidity.   Kay could then run the table on its nearest competitors.  Zale’s Canadian stores would be a great acquisition, so too would be any of a number of well positioned up market jewelry competitors.  You will note I didn’t say Zale would be a good buy.  I still believe any one time cost advantages from buying Zale stores would be more than offset by the cannibalization of future sales in the duplicated markets, future store closures as the markets were rationalized, and increased future operating costs.   

Other winners would also include some large and mid-sized up market jewelry chains.  For instance, Tiffany has begun rolling out it small format stores in California.  These stores will benefit from fewer competitors for aspirational products, as well as, less market clutter, making it easier for them to frame their new offer to consumers.  Other mid-sized luxury jewelry chains could also benefit such as Helzberg Jewelers and Fred Meyer Jewelers.  Operating about 270 and 396 stores respectively, these two better jewelry companies are owned by Berkshire Hathaway and Kroger.   

However, the largest beneficiary will be many of the 24,000 independent jewelers and small jewelry chains.  Closer to the customer and more specialized, these stores are positioned to benefit the most as the number of mid-market, large jewelry chain competitors decline and consumers become more discriminating in the face of higher prices and less discretionary income. 

Implications: Years of sales declines and current operational loses, probably means Sears can't be saved.  Here's why. 

Analysis: I am not sure Sears lost out to Costco as much as it’s just a looser, at least under its current management.  Sears Holdings the result of the merger of Sears Roebuck and Kmart hasn’t had a comparable store sales increase since the deal in 2005.  Granted the holding company generated significant earnings and cash in the beginning.  But that was a consequence of one time gains from the consolidation of the two companies.  Two years later, the company is losing money.  

First billed as a real estate play and as a hedge fund gambit where Sears’ huge cash flow would be invested in growth businesses, neither materialized.  Most of the excess cash was diverted to overpriced stock buy backs and system improvements which were supposed to increase the retail stores efficiency.   That’s a polite way to say the investment in systems was to be paid for by termination and early retirement of most of Sears’ higher paid, experienced field personnel.  

Unfortunately, that’s about the only thing hedge fund manager and holding company chairman accomplished during his disastrous two years as Sears’s chief strategists.  In retrospect, his actions were tantamount to the same thing Circuit City executives were accused of when they arbitrarily fired their most experienced, higher paid employees.  Now Sears’s probably has by far the worst field organization in the retailing industry. 

The HR factor in retailing has plagued ‘big box’ store operators for several decades.  Department stores have been moderately successful in eliminating sales staff, while shifting the stores to a self service environment.  With the exception of a select few brands like Saks or Neiman Marcus, it’s not uncommon to have entire departments in serviced by one employee, while anxious customers search for someone to take their money.  Macys’ is even experimenting with selling branded, personal electronics through a vending machine; anything to eliminate the human factor in retailing.   

While Sears’s hasn’t reduced its store offer to the level of vending machines, at least not yet, the stores are seriously understaffed and untrained.  In a business that historically specializes in products