Summary
As Finlay methodically roles out its "unannounced" plan for liquidation, its problems begin to spill over to Zale's beleaguered balance sheet. Here's why Zale may be the fourth large jewelry to sink into financial obscurity over the next 24 months.
Analysis
According to Reuters, Finlay’s CEO agreed to a modified retention bonus effective March 6, 2009, but despite the description, its sounds like a negotiated severance package. Arthur Reiner, CEO and architect of the company’s questionable turn around strategy agreed to “forgo a future $2 million severance payout for a $1 million bonus deal”. Half of that amount was to be paid “within five days of the agreement”, the remainder on or before April 1st if Reiner was still employed by Finlay. With hundreds, possibly a thousand or more workers likely to lose their jobs, unsecured creditors probably losing 70-75% of their receivables, and bondholders taking a big haircut on their investment, the revised deal may still seem over the top to some. After all it was only weeks ago Finlay coerced some large unsecured suppliers into agreeing to extend payments for pre Christmas merchandise until August. Then the alternative was immediate bankruptcy.
Now there is every possibility Finlay won’t be in business weeks from now, much less in August. Moreover, cash freed up in the exchange won’t be used to aid the company’s turnaround, but rather to facilitate the termination of the business and to pay executive severance. There isn’t anything illegal about the deal, however, it does underscore how unsophisticated jewelry industry wholesalers and manufacturers can be when confronted by adversarial corporate finance departments and sophisticated institutional investors.
It’s uncertain whether Reiner will continue past March. Clearly a volatile, forty store jewelry business in the midst of a turn around can’t support a million dollar plus CEO. Also, it remains to be seen if the skill sets required to build such a chain are necessarily the same as those necessary to run a billion dollar retail enterprise such as Finlay was in the past. Still Reiner can be credited with conceiving the plan to mitigate Finlay’s deteriorating department store business by acquiring specialty jewelry stores like Carlyle and Congress. Unfortunately, it was his same plan that pushed Finlay over the edge when the board bet the company’s future by acquiring about 70 Bailey Banks and Biddle stores from Zale Corporation for $200 million. All financed with debt.
In hindsight, the decision was ill timed to say the least. But after a year in business, it appears the company also bought the wrong chain of stores too. Finlay announced it was closing about forty specialty retail stores. While it hasn’t announced which stores will be closed, the combination of stores for both Carlyle and Congress were all operationally profitable last year. So, while still an assumption, it’s likely the majority of the store closures will be BB & B stores. Closing approximately half of the BB & B stores has to reflect poorly on management’s understanding of the specialty store business, notwithstanding the recession.
What will happen next? That’s anybodies guess and if recent events are the measure, management still hasn’t told the whole story to its remaining employees and creditors. For instance, it’s problematic whether the current bond holders will be willing to refinance the concept of a new national guild jewelry chain. So who will? Venture capital is almost non- existent in today’s credit market. Even if they could find private equity money to take out the bond holders and refinance the business, who would run it? After all Venture capital partnerships invest in entrepreneurial management with a vested stake in making the business succeed. That doesn’t describe Finlay’s current management, leaving either the Cohen or Congress family to step up to the plate to risk their family’s net worth to build the new concept. Saving that or a white knight willing to buy the specialty stores, secured creditors will eventually demand the liquidation of the three remaining brands to recover as much of their investment as possible.
In the meantime, Finlay’s problems will begin to spill over onto Zale’s balance sheet. Surprisingly despite the announcement that Finlay would be closing 40 specialty stores, Zale made no provision for the pending liability in its 2nd quarter 10Q financial statements. Citing a lack of precise information, Zale management chose only to disclose Finlay’s intention, thus understating their liabilities. Whether that’s proper accounting remains to be seen. Perhaps it was an underlying reason why Rodney Carter, the company’s most recent CFO, left Zale so suddenly in order to protect his professional credentials? Keep in mind the $70 million liability is an incremental cash cost to a company that is likely to lose a lot of money in 2009. In my opinion, that’s a material event.
Also, in this economy, management can’t cavalierly dismiss it saying landlords will settle the claim at a substantial discount in order to release the space. The fact is it could take months, if not years, for developers to release the space and then not for the current lease values. They may not want to sacrifice higher current cash flows for lower ones in the future, especially in this economy. All the while, Zale is trying to renegotiate lower rents for its continuing stores. Anyway, at best it’s one of those border line accounting decisions, at worst it materially misrepresented the value of the company. Little wonder Zale’s stock has been selling at near penny stock values despite the upward trends in the DOW.
For practical purposes Finlay is already gone making it the third large chain in the top five to go out of business in the last two years. The first was Friedman in the spring of 2008, then Whitehall in the fall, now Finlay. Who’s next? If current performance is the measure, Zale could well be the next casualty. If true, pundit’s earlier prognostications that the industry would consolidate, leaving only a handful of large chains, like the department store sector, will have been woefully wrong. If anything the historic wheel of retailing is spinning faster than ever which favors the emergence of smaller, highly differentiated stores at this time. Such will be the likely fate of large jewelers unless something or someone changes how large chains are managed in the near future.
