Summary
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.
