Root Causes of Friedman Jeweler's Failure Endemic to Jewelry Industry

Implications: Friedman's failure is not as much a consequence of a bad economy or poor strategy as it is about the motivations of its owners and how the business was financed.  Here's why.

Analysis:  Friedman Jewelers announced that it was starting going out of business sales in about 377 stores.  Friedman’s was forced into involuntary Chapter 7 bankruptcy in January by four of its jewelry creditors.  Later, the court approved the company’s petition for Chapter 11 reorganization.  However, after finding no buyer for the business and an unsuccessful auction, a Delaware court approved the company’s plan to liquidate about $400 million of inventory at retail and close most of its stores.  One mall official said “[We were told] only last week were told that the [Friedman] store was liquidating. She said a new tenant has not been lined up, but the nearly 1,700-square-foot space will be marketed to interested parties like any other area”, according to NewsGazatte.com.

Court documents indicate the company is in negotiations to sell about 78 mall locations to WFC Acquisitions, a part of Whitehall Jewelers Holdings Inc.  Whitehall currently operates about 314 stores under the trade names Whitehall, Lundstrom Jewelers and Marks Bros. Jewelers. However, to date, that deal isn’t final, so it remains to be seen whether any of the Friedman locations will survive the liquidation as a jewelry outlets.

According to the Deal.com, the March 6th auction was “a war” between the company’s unsecured creditors and the investment banker facilitating the process.  The article went on to say, court documents filled later indicated that the best bid for the company was $72.5 million which was a superior bid to that offered by Harbinger Capital Partners Master Fund I, the majority owner.  The documents also mentioned that Whitehall Jewelers Inc. also “present[ed] some sort of bid” for the company.

The article continued, saying that Harbinger bid about $65 million for the Friedman’s assets.  That’s about the amount of debt owed to Friedman’s (not Crescent’s) secured creditors. Evidently the higher offer made by the unknown bidder wasn’t satisfactory to the unsecured creditor’s committee’s since the court concluded the company’s liquidation was in the best interest of all classes of creditors.  Looking back, I think it is clear that Friedman’s failure was more than just an isolated incident that can be attributed to a bad economy or a poor strategy.  It’s about the motivations of its owners and how the business was financed. 

The story actually begins in December 1987 when Peoples and Swarovski bought Zale Corporation. That deal was put together by Morgan Schiff & Co. and Phil Cohen.  Cohen, a master of structuring highly leveraged buyout was impressed early on by the high returns of the Zale deal.  That led to his buyout of Crescent Jewelers in 1988 and Friedman’s in 1990.  Later Friedman’s would file Chapter 11.  Critics pointed to the company’s strategy of opening stores in strip centers, SEC investigations, and charges of fraud as being Friedman’s undoing.  But the catalyst of the default and ensuing litigation was probably Cohen’s desire to recoup his initial investment in Crescent Jewelers.

Bradley Stinn, Chairman and CEO of Crescent was quoted as saying: "It's been 10 years since the leveraged buyout, and Crescent shareholders need to see a financial return. So Crescent has two considerations: to get liquidity for the investors by going public as an independent company or by merging into some other entity, Friedman's being most likely."  Stinn was also the President and CEO of Friedman Jewelers too.

There was concern at the time that Friedman’s continued investment in Crescent limited the company’s development of its off-mall strategy.  Sinn’s reply, "The number one fallacy is that the Crescent investment has kept Friedman's from doing something it would have otherwise done. That is flat out wrong. If that money didn't go into Crescent, it would be in the bank now, earning interest."  The company’s future restructuring would probably prove his statement wrong.  Nevertheless, one thing is certain; the investment in Crescent provided Cohen with the liquidity he wanted.

Stinn was recently convicted of fraud and conspiracy for covering up Friedman’s losses from its installment credit sales.  Just what role the investment in Crescent Jewelers played is uncertain.  But it seems clear that it was important catalyst in the company’s decision to drive higher sales by applying lower standards for granting credit to diamond customers.

Friedman’s second bankruptcy was for different reasons, but the catalyst may have been similar, owner liquidity.  Four trade creditors petitioned the courts to force the company into a Chapter 7 liquidation fearing hedge fund owners Harbinger Capital were preparing to file a petition for Chapter 11 reorganization. Such reorganization could have left unsecured trade creditors with tens of millions of worthless debt while company owners recouped their investment.  Results of the auction of the company on March 6th suggest trade creditors were probably correct.

Unfortunately Friedman isn’t the only company where the motivations of majority owners, ordinary investors, and management may conflict.  For instance, Zale Corporation has been in decline for years.  Today, Zale’s board is predominantly composed of non-jewelry, non-retail professionals and hedge funds, three of which control about 28% of the company.  Recently trading at almost 30X earnings, investors recognize there’s little hope for a turn around under current management, however, they are speculating the company will be either sold to an overseas buyer or further broken up to recoup the hedge fund’s several hundred million dollar investment.  The list doesn’t end with Zale, there are others.

Finlay Enterprises is facing a liquidity problem that will ultimately require outside capital to resolve. The largest jewelry lease department operator in the US, the company is desperate to grow its mall based luxury store jewelry segment in order to offset both the loss of departments and declining jewelry department comparable store sales.

The most highly leveraged of any of the public jewelry companies, Finlay recently bought 70 Bailey, Banks, and Biddle stores from Zale for about $200 million.  If it can make BB & B profitable and that is a big if, the company will need additional cash to reduce leverage and continue to grow the luxury segment of its business.  Just where that cash will come from is unclear.  Now selling as a penny stock, the company was recently notified that it had 90 days to improve its market capitalization or risk delisting by the NSADAQ Exchange.  Just what form Finlay’s capital structure will take two years from now is anybodies guess.  But if Friedman and Zale are the measure, their success or failure will be dictated as much by whom the investors are as by the covenants and size of the investment.

Liquidity problems and financing issues aren’t just large jewelry company problems.  Smaller public companies are also facing similar difficulties.  One example is Whitehall Jewelry Holdings Inc.  Similar to Finlay Enterprises, Whitehall also trades as a penny stock.  Having secured additional financing in January 2008, the company’s core stores continue to bleed cash.  Whitehall is negotiating to buy some of Friedman locations.  If the deal goes through, the company will increase its size by about 20%.  That’s a lot of growth for a company with an unproven retail strategy.  Whitehall hasn’t said where it will get the cash from to buy the stores.  No stranger to conflict, Whitehall nearly failed because owners and investors couldn't resolve their difference.  What tension remains is uncertain.  But additional leverage and higher risk will make operating the company more problematic as interests diverge.

Including Friedman’s, these four businesses account for about 16% of the nation’s dedicated jewelry store outlets which are either being closed or are in serious financial and strategic distress.  In terms of numbers, we are talking about 3,800 leases, 22,500 jobs and approximately $2.6 billion in assets are now in play. And that’s only public companies. 

Industry participants, capital providers, and investors alike should take note of the instability of the jewelry segment; especially now.  Previous assumptions about what drives the business, the relevance of non-jewelry management in a turn around, liquidity of the industry, and future growth expectations should be reexamined; not only because of Friedman’s failure, but also because of changes in the global demand for commodities and changes in US consumers buying behavior.