Zale, Finlay and Those Bailey Banks Leases

I always receive a lot of inquiries about the Finlay/Zale/Bailey Banks lease situation, so I should note that Zale addressed it in its recent 10-Q:

In connection with the sale of the Bailey Banks & Biddle brand on November 9, 2007, the buyer, Finlay Fine Jewelry Corporation ("Finlay"), assumed the obligations for the store operating leases. As a condition of this assignment, we remain contingently liable for the leases for the remainder of the respective current lease terms, which generally range from fiscal 2009 through fiscal 2017. The maximum potential liability for base rent payments under the leases totals approximately $71 million as of January 31, 2009. In addition, we may be obligated for common area charges and other payments. On February 26, 2009, Finlay announced its intention to close a number of its specialty jewelry stores, but did not indicate the number of Bailey Banks & Biddle stores that will be closed. Finlay has not informed us when it will finalize their store closure plans, but it could be in the near term. We have not recorded a liability for any of these leases at this time based upon, among other things, our current assessment regarding the likelihood of payment. There can be no assurance that this assessment will prove accurate.

A couple of thoughts:

- Finlay’s recent reorganization seems to have not ended the doubts about them; just today, a U.S. News story included them in a list of “companies at risk of failing.” Many people question why Finlay would give up the leased business that has been its bread and butter, and how it can handle its not-insignificant debt with a chain (now) comprised of 40-some stores.

- That $71 million figure is lower than the $80 million Zale has quoted in the past. Why the difference? [UPDATE: I am now informed that this is because Finlay has paid off more of its leases, and the number will continue to lessen as time goes on. Makes sense.]

As I’ve said before, my understanding is that, even in the worse-case scenario, Zale will likely not be liable for the full amount, as there may be some negotiating with landlords who don’t want vacant stores.

- Is it just me, or is it strange that Finlay "did not indicate" to Zale which Baileys stores are being closed, given this issue could end up important to Zale? Shouldn’t they talk?

- Zale’s decision to sell Baileys to Finlay seems like one of the rare deals that has not worked out well for either side. It increased Finlay’s debt and put Zale on the hook for those leases. And Zale used some of the sale money for a stock repurchase, which seems ill-timed given what’s happened to its share price.

UPDATE:  Also worthy of note, in Zale’s filing:

Under an arrangement with Citibank, N.A, Citibank provides financing for our customers to purchase merchandise through private label credit cards. The arrangement also enables us to write credit insurance. Customers use our Citibank arrangements to pay for approximately 40 percent of purchases in the U.S. and approximately 25 percent of purchases in Canada. Under the agreements governing our arrangement, our Canadian and U.S. subsidiaries must satisfy various financial and other covenants. Our Canadian subsidiary currently does not satisfy a fixed charge coverage covenant. As a result, Citibank has the right to terminate the agreement with that subsidiary. Our U.S. subsidiary currently does not satisfy a minimum sales threshold. As a result, Citibank may require our U.S. subsidiary to pay a fee equal to the fees that would have been paid had the minimum sales threshold been met. If we determine not to pay the additional fee, we have 180 days in which to move the private label card program to another provider. We currently are in discussions with Citibank regarding the covenant violations and the general operation and economics of the arrangement. To date, Citibank has not sought to terminate either agreement, although they have requested a letter of credit. Any disruption in our arrangement with Citibank, particularly in the current credit market in which replacing Citibank might be difficult, would have an adverse effect on our business, especially to the extent that it materially limits credit availability to our customer base.