Art Reiner, chairman and chief operating officer of Finlay Enterprises, was uncharacteristically quiet on a recent conference call with Wall Street analysts. In a review of third quarter results – total revenues were up, though core sales were down, and profits were down – Reiner did not bring the usual detail and “color” to his prepared presentation.

 

Instead, he kept highlighting concepts such as “managing expenses, monitoring cash, and intensifying marketing.” In this recessionary environment, these concepts are clearly – and correctly – the most important things on Reiner’s mind.

 

Still, our impression was one of an embattled chief executive talking. After all, he’s just renegotiated Finlay’s cumbersome debt, with interest rates at double-digit levels on some portions; he’s fighting to keep cash flowing in the face of weak demand; and, he’s trying to move Finlay from a company totally reliant on leased departments to a company engaged in selling fine jewelry through guild jewelry stores.

 

Further, he’s facing too many people who have given up on Finlay. Vendors are reticent to help Reiner and his company, and no Wall Street analysts asked questions at the end of the conference call.

 

Finlay is in a difficult business: operating leased departments is one of the toughest retail categories because their destiny is further beyond their control than just about any other retail category. Their host stores tell them when they will open and close; the hosts dictate most of the leased department’s operational procedures; they dictate advertising levels and expenditures. Finlay’s rent factor is more that double that of a traditional specialty jeweler. And in Finlay’s case, the company has always carried unusually high debt levels, when compared to others in the industry. Thus, its bankers have a lot to say about how the company runs its business.

 

We’re not going to speculate on Finlay’s future. Its specialty jewelry division appears to hold much potential, but total corporate debt levels are an albatross. Our guess is that if Reiner could wave a magic wand, he would exit the leased department business (though he is one of the few in the industry who can navigate those treacherous waters), jettison the debt somehow and focus on the guild jewelry operation. But magic wands exist only in fairy tales.

 

Third Quarter Highlights

Because Finlay is a company in transition, it is sometimes difficult to understand its reported results. For example, the company reported that its total sales in the third quarter ended October 2008 were up 12.9 percent, but same-store sales fell by 13.5 percent (and declined by 14.9 percent if discontinued operations are included). How do you explain such a disparity in reported sales? Simple: Bailey Banks & Biddle (BBB) sales were included for the full third quarter this year versus only a partial quarter last year. Our analysis below dissects sales by division for Finlay.

 

The table below summarizes third quarter financial highlights.

 

 

• The entire increase was driven by the BBB stores which were acquired in November 2007. Management did not give much narrative detail about its sales deterioration, but it did provide enough numbers that we were able to analyze trends during the quarter.

• While it is technically correct that sales were up by 12.9 percent, it does not provide a snapshot of current trends. If BBB had been included in last year’s third quarter for the full thirteen weeks, Finlay’s revenues in the third quarter of 2007 would have been $192.936 million, rather than the reported $141.918 million. The table below, with dollars in millions, illustrates the “apples-to-apples” revenue comparisons for the third quarter.

Source: Company reports

 

Based on numbers in the company’s legal filings, Finlay’s third quarter total revenues were actually down by nearly 17 percent. The largest shortfall came in the specialty jewelry division which consists of BBB (67 stores), Congress (5 units), and Carlyle (35 units). Revenues in this division were off by just over 22 percent, if BBB had been included for the full quarter last year.

 

The company’s leased department division posted sales that were down 13.6 percent. Finlay operates leased departments in 216 Macy’s Central stores, 57 Macy’s North units, 36 Macy’s Northwest stores and 34 Bloomingdale’s units, for 343 leased departments. At the end of 2008, Finlay will close 93 Macy’s leased departments. Further, Finlay will close 47 Lord & Taylor departments at the end of 2008.

 

• The following table summarizes sales by product category. The percentage change (far right column) is year-to-date; all other data is for the third fiscal quarter. The numbers represented the company’s “reported sales,” unadjusted for the inclusion of BBB for the full three-month period last year or other adjustments.
  
  A typical specialty jeweler generates about 50 percent of its sales from diamonds and diamond jewelry. Clearly, Finlay’s leased departments, with 24 percent of sales from diamonds, are well below this industry average. What’s surprising is that the diamond sales mix at its specialty jewelry stores is also below the industry average. Based on the numbers, BBB will help push up Finlay’s diamond sales mix in future periods.

Source: Company reports

 

• Finlay’s gross margin declined to 41.8 percent of sales versus 45.1 percent in last year’s third quarter. The variance is primarily due to an increased mix of sales from the specialty jewelry division (Bailey Banks & Biddle, Congress, Carlyle, J.E. Caldwell and Park Promenade) which are inherently lower than gross margins generated by its leased departments. In addition, a higher LIFO charge hurt margins; this was due to higher commodity costs. Finally, leased departments in Macy’s and Lord & Taylor stores which are slated to close had a negative impact on margins.

• Operating costs rose to 55.1 percent of sales from last year’s 48.7 percent due primarily to de-leveraging from lower sales. In addition, incremental rent expense from BBB hurt by about 230 basis points. Further, the company paid about $800,000 to consultants to help restructure the company’s debt. Finally, there was about $400,000 in severance associated with some store closings.

• Owned inventories rose on a consolidated basis. Here’s an analysis of inventories by division:

• Owned inventories in the leased departments declined to $283 million from last year’s $367 million due to better management and liquidations related to unit closings.

• Owned inventories in the specialty jewelry division were $313 million, up from last year’s $91 million. The increase is due to the addition of inventory associated with the BBB stores which were acquired during the third quarter last year.

• Consignment inventories in the leased departments were $136 million this year, down 25 percent from last year’s $181 million. The company is much less reliant on consignment inventory in the current period than in prior periods.

• Consignment inventories in the specialty jewelry division were $31 million, up from last year’s $19 million.

• Total consignment inventories were $167 million versus $200 million last year.

• Total owned inventories were $596 million compared to $458 million a year ago.

• In short, it is clear that Finlay is moving away from consigned inventories. Five years ago, consignment inventories represented about 58 percent of total inventories; today consignment inventories are only 22 percent of total inventories, a level which is more in line with traditional specialty jewelers (whose levels typically run in the 10-15 percent range, though the range can be much wider).