Finlay (FNLY) Results Disturbing

Implications: Finlay's declining margins and narrow credit line, in combination with an industry perilous close to a price war suggest investors, vendors, and capital suppliers should be concerned.  Here's why. 

Analysis: Wall Street recognizes that Finaly Enterprises is a high risk investment.  Selling for around $0.35 per share, the near billion dollars, jewelry department lease operator has a market capitalization of only $3.3 million.  With the exception of insiders that own about 27% of the company and institutions that control another 33%; few investors give Finlay’s penny stock a second thought today.  Nonetheless, Finlay remains a significant player in the $65 billion retail jewelry segment and if it should default, it would have far reaching consequences for the industry now and in the future.  

For the last five years, Finlay’s management has been repositioning the company from that of a jewelry department lease operator to a diversified jewelry retailer, consisting of both department store jewelry departments and high-end luxury specialty jewelry stores.  In November 2007, Finlay bought about 73 Bailey Banks and Biddle stores from Zale for approximately $200 million.  Already highly leveraged, Finlay financed the deal through an extension of its working capital line.  Now about 39% of Finlay sales are from its specialty jewelry stores, but the cost for that diversification was a weaker balance sheet.  Finlay’s debt to equity ratio is now about 85%. 

According to the company, about $103 million remained on their existing line of credit at the end of the second quarter.  However according to the terms of Finlay’s working capital agreement, only about $74 million will be usable in the second half.  That’s not much as the company begins to build inventories and pay for advertising for the all important Christmas quarter.  Like most jewelry companies, Finlay’s cash flow will be negative in its third quarter and for the first part of the 4th quarter too.  Assuming the company can get sufficient vendor financing to keep them within their working capital covenants,  a decline in sales could still push the company into default during the fourth fiscal quarter.  That’s very real possibility because of heightened price competition this fall.  

Competition for the consumer’s discretionary dollar will be more intense this year than ever.  Whether its inter-competition between luxury electronics items, travel, and jewelry or intra-competition between jewelry stores, 2008 is shaping up to be the most competitive in two decades.  In particular, there will be more jewelry on sale at bigger discounts than in recent history.  The sales will start earlier too.  Whitehall has already begun its closeout of about three-quarters billion in jewelry, while Friedman continues its $400 million jewelry liquidation through November in selected stores.  Zale is continuing its 70% off inventory reduction, at least part of it, into the 3rd quarter.  What all this early discounting means remains to be seen, but it is shaping up to look a lot like the beginning of a price war as Christmas gets closer.   

Zale CEO Neil Goldberg was quoted as saying the closeout sales won’t affect the company’s business.  That’s probably because they plan to be on sale ‘big time’ despite protests to the contrary.   Terry Burman, Signet’s Group CEO said earlier in the spring that Zale’s clearance may have cost Kay one or two percentage points in growth in the first quarter.  That was then, but few jewelry businesses can afford to stand idly by while the competition steals sales in the Christmas quarter where jewelers make most, if not all of their profit. If Zale drops price to meet its aggressive sales goals, other jewelers will probably follow.  That could result in lower margins and a number of bankruptcies after Christmas which could include Finlay.  

Another Finlay issue is margin rate.  The company’s gross margin declined in the second quarter to 44.5% from 46.8% the previous year.  Part of that decline was due to LIFO adjustments; however a significant portion was also due to the increase in specialty stores sales which are lower margin than the company’s traditional core department store business.  How much lower?  Well, Finlay’s gross margin in FY05 was 49.6% when the company was predominately a jewelry lease department store business.  Since then its gross margin has steadily declined.  For example, gross margin rate was 48.9%, 47.1%, and 45.5% in fiscal years 06, 07, and 08 respectively.   During the four preceding years Finlay’s gross margins have declined by about 103 basis points per year on average.  Using that trend, Finlay’s likely gross margin for Fy09 would be about 44.5%.  So a critical question for investors, bankers, and suppliers alike is: Will Finlay’s gross margin continue to decline this year? 

The math aside, the answer is still yes.  In part because of the aforementioned price instability in the market, but also because of an unfavorable shift in product mix in the Bailey, Banks, and Biddle brand. When Finlay did its due diligence on the Bailey, Banks, and Biddle acquisition it’s doubtful financial planners understood the consequences of the chains historical positioning as a watch store.  In fact, whether under the BB & B brand or the 30 or so trade names that operated as Zale’s Fine Jewelers Guild, watches were always the largest sales category of the brand.  That was especially true when the company was the largest US retailer of Rolex watches in the late 1980’s.  National brand watch advertising was the predominant focus of the luxury jewelers media plans for nearly 20 years.  So it shouldn’t come as any surprise that 35% to 40% of the chains revenue came from lower margin watch sales.  Despite many attempts to shift the sales mix to the higher margin diamond jewelry products, consumers instinctive sought out Bailey, Banks, & Biddle stores for luxury watch and gift brands.  By the time Finlay acquired B.B. & B its luxury watch sales had grown to more than 40%.  Now Finlay wants to increase diamond sales and decrease the brands dependence on watches.   But consumers don’t think of B.B. & B first for fine diamond jewelry.  So Finlay will have to change their perception of the brand. 

Whether Bailey, Banks, and Biddle can be repositioned at all is problematic, but for sure it won’t happen in a year.  That’s why Finlay’s gross margins may decline further as Bailey’s watch business grows.  Finlay’s mix problem is even bigger this year, now that luxury watches are in greater demand.  The sales of fine watch brands have held up better than other jewelry products during the slow down.  If that trend continues into the Christmas quarter, then the watch sales increases in B B & B may be disproportionately large and Carlyle diamond sales growth could flatten out.  That combination will push Finlay blended margin rate down even further this fall.  

Unfortunately, historical numbers and the economy are working against Finlay.  Also, there is the emerging question of whether the Bailey, Banks, and Biddle was the right acquisition at the right time or the wrong one for any time.  If Finlay has to restructure, it will be mess.   Nearly 60% of the companies business is done with large department store chains like Dillard and Macy’s.  The remainder is through stand alone mall stores.  Clearly the department store business would continue, but Finaly probably wouldn't manage it.  Macy’s, Finlay’s largest department store customer already has an in-house jewelry buying capability and has just announced it was launch its own jewelry brand with price points up to $895.  Whether they would buy Finlay’s inventory isn’t clear, especially now that gold is declining in value.  That would mean the disposal of hundreds of millions of inventory would have to be done through 105 specialty stores which would destroy the creditability and value of those brands.  

It would also have a ripple effect through out the supplier segment of the industry.  Consignment vendors at best would get their unsold inventory back.  Asset suppliers could get as little as $05 on the dollar for their receivables.  That could mean an end for many suppliers already weakened by earlier Friedman and Whitehall bankruptcies. Consignment suppliers wouldn’t incur the same degree of loss, but would have additional restocking and marketing costs to sell the goods provided they had credit lines to hold the inventory.  

As secured creditors, banks would probably come out whole, less opportunity costs of the funds, but would be more reticent to make loans to jewelry related businesses.  Tighter credit would slow industry growth and further weaken the industry.  Clearly Wall Street has lost confidence in Finlay’s turn around plan.  It remains to be seen whether the industry can afford to keep faith with what may be a fast ‘sinking ship’