Ripple Effect

To some observers, it seemed like déjà vu when Friedman’s Inc., the Savannah, Ga.–based chain that at its peak operated more than 700 stores in 22 southeastern and midwestern states, filed for Chapter 11 bankruptcy protection on Jan. 14. Although Friedman’s route to bankruptcy involved some unique twists and turns, it’s reminiscent of the woes that have befallen other large jewelry chains, including Zale (filed Chapter 11 in January 1992), Service Merchandise (filed in March 1999 and went out of business in 2002), and Samuels (which has been in bankruptcy court three times since the early 1990s, most recently in 2003).

Friedman’s—the third-largest U.S. retail jewelry chain, behind Zale and Signet’s Sterling Jewelers—is now attempting to pick up the pieces. In mid-February the company, which serves low- to middle-income consumers, announced plans to close 165 stores (before filing for bankruptcy, it had terminated business operations at 78 locations, according to court documents). In a late March 8-K filing with the Securities and Exchange Commission, Friedman’s projected a net loss of about $46.9 million for 2005 and stated it did not expect to emerge from Chapter 11 until after the calendar year. Will the chain’s debt have a ripple effect through the industry?

Topping the list of the top 30 unsecured creditors (amended and filed in U.S. Bankruptcy Court on Jan. 21) are M. Fabrikant & Sons (owed more than $17 million), Rosy Blue Inc. (nearly $10.7 million), Design Works (more than $7 million), C. Mahendra Jewels (more than $6 million) and Sumit Diamond Group (nearly $4.3 million). And many smaller suppliers are owed money, as well. In an affidavit submitted to the court on Jan. 18, Friedman’s CEO Sam Cusano said the company had “several thousand creditors and parties-in-interest.”

What might happen to the jewelry manufacturers who can ill afford to take a big hit when a large client like Friedman’s goes bankrupt? “These things do take their toll on companies,” says Dione Kenyon, president of the Jewelers Board of Trade. “It depends on how much of their capital base they’ve gambled.”

What Happened at Friedman’s

Paul Resnik, assistant director of research at J.M. Dutton & Associates, an independent investment research firm, notes that it’s difficult to get a true picture of Friedman’s financial circumstances. On Nov. 17, 2003, Friedman’s announced it had determined that its financial statements for the fiscal years ending Sept. 30, 2000, through Sept. 30, 2002, and the first three quarters of fiscal 2003 were to be restated and should not be relied upon. On Jan. 24, 2005, after Friedman’s had filed for Chapter 11 protection, its audit firm, Ernst & Young, said it would discontinue its relationship with the company and would not complete either the restatement of prior financial statements or the audit of fiscal years 2003 and 2004.

“It’s very hard to figure out where this leaves shareholders and what brought [Friedman’s] to this point,” says Resnik. “It’s like reading a 500-page book and finding that the publisher neglected to print the last 20 pages. I keep waiting for the rest of the story.”

“Some people who are trying to measure Friedman’s progress in its reorganization cases may find it somewhat challenging, because there is no reliable historical financial information to use as a benchmark,” says Jack Butler, a partner and co-practice leader of the corporate restructuring department at the law firm of Skadden, Arps, Slate, Meagher & Flom LLP, the lead attorney representing Friedman’s in its Chapter 11 reorganization case. “But the company has started to file some financial information. Friedman’s is filing monthly operating reports with the bankruptcy court, and that information is also filed publicly on an 8-K. The company filed a summary of its 2005 business plan on an 8-K in March.”

Cusano, who became Friedman’s chief executive officer in June 2004, was the CEO of Service Merchandise when Service filed Chapter 11 and went out of business. In his January 2005 affidavit to the bankruptcy court on behalf of Friedman’s, Cusano detailed the Savannah chain’s troubles.

  • Friedman’s and Crescent: Friedman’s relationship with Crescent Jewelers, a West Coast retailer that filed for Chapter 11 protection in August 2004, has generated a large loss of liquidity. According to Cusano’s January affidavit, Friedman’s publicly held Class A shares carry the right to elect only 25 percent of the company’s directors. The company’s Class B shares, which have all other voting rights, are held by one entity, MS Jewelers. “It is my understanding that certain of the investors in MS Jewelers … may also hold indirect investments in Crescent,” Cusano’s affidavit says. “Beginning in 1996 and continuing through 2002, Friedman’s made a series of investments in Crescent that culminated in Friedman’s direct investment in Crescent in 2002 in the aggregate amount of $85 million…. Crescent is currently in default on its interest obligations to Friedman’s.… Today, this investment has grown to nearly $100 million due to unpaid interest and accrued dividends.”

  • Inventory: According to Cusano’s affidavit, when he arrived at Friedman’s, “Merchandise vendors were not being paid on a timely basis, resulting in a substantial cessation of merchandise shipments and a deteriorating inventory base.” To address this problem, the affidavit says, Friedman’s organized a committee of its vendors and negotiated a trade credit program that gave the vendors a lien against the assets securing an amended credit agreement referred to as the “prepetition facility.” The vendors agreed to ship merchandise for the 2004 holiday and 2005 Valentine’s Day seasons. “Due to the timing and implementation of the Prepetition Facility and the Vendor Program, and despite the cooperation from many of Friedman’s vendors, a number of Friedman’s vendors were not able to meet their obligations under the Vendor Program in accordance with their timing commitments to the Company,” the affidavit says. “Delayed inventory receipts required for its 2004 holiday selling season contributed to Friedman’s sales and financial performance not meeting projected results.…”

  • Lenders limit funding: In the midst of its dismal holiday season, Friedman’s and its lenders agreed to modify financial covenants of the prepetition facility in November and December 2004. In late December and early January, Friedman’s sought a third amendment, but the lenders denied the company’s request. “On Jan. 10, Friedman’s received a reservation-of-rights letter from the prepetition lenders alleging certain events of default,” Cusano’s affidavit states. On Jan. 11, the company sent a letter to the lenders urging their continued support. According to the affidavit, “The Prepetition Lenders responded by suspending funding of much of the Company’s ordinary course financial obligations resulting in the dishonoring of millions of dollars of checks. …” On Jan. 14, Friedman’s received a notice of default of its vendor program. The company filed for Chapter 11 protection that day.
    Butler, Friedman’s attorney, notes that because of the timing of these events, the company had no opportunity to complete any assessment of potential store closings and strategy changes in advance of the bankruptcy filing. “Friedman’s is making, in many respects, remarkable progress, in light of the fact that the company had no opportunity to prepare for Chapter 11.” The company has obtained debtor-in-possession financing from Citigroup, which will fund its operations while the company is in bankruptcy.

  • Business strategy: In its expansion from 50 stores to 700 in the decade following its initial public offering in 1993, Friedman’s pioneered the strategy of locating its stores in strip centers rather than malls. As of July 2003, about two-thirds of the retailer’s stores were in “power centers”—those anchored by a big-box retailer like Wal-Mart or Target. Though other major chains have opened some strip-center stores, few seem interested in picking up where Friedman’s is leaving off. In Zale’s second-quarter conference call on Feb. 18, Zale chief operating officer Sue Gove said that while her company is considering purchasing some of Friedman’s mall-based stores, the strip-center stores do not fit in with Zale’s strategy.
    In the March 28 8-K filing, Friedman’s says that among other approaches, it plans to focus on “a store closure and inventory liquidation process designed to cure historical overexpansion.”
    Another component of Friedman’s past strategy that may have contributed to its downfall was its liberal credit policy. Before the bankruptcy, more than half the company’s sales were charged to Friedman’s proprietary credit cards, according to published reports. Marketing of these cards to low- and middle-income consumers stressed easy terms and instant approval. Friedman’s associates encouraged customers to come into the stores to make payments in person, on the theory that this would encourage additional impulse purchases.
    “Can a strip-center jeweler selling budget jewelry ever really be successful on this [large] scale?” asks Howard Davidowitz, chairman of Davidowitz & Associates Inc., a national retail consulting and investment- banking firm headquartered in New York. “The book is out as to whether this is a survivable concept.”
    “Whether you or I agree with it, as a purely economic model, that’s wonderful,” says jewelry-industry analyst Ken Gassman of Richmond, Va. “Zale would love to see their customers once a month.”
    According to Friedman’s 8-K filing, “The Company’s goal in the merchandising area is to better use merchandising to drive sales and margins, while also using Friedman’s unique credit offering…. The Business Plan contemplates moving away from being solely a ‘credit provider’ and back to executing basic and fundamental retail practices.” Says attorney Butler, “The particular part of the market that Friedman’s plays in requires that it operate its own independent credit program. But Friedman’s wants to be a fine jeweler that sells jewelry and has a credit program, instead of being a credit-driven business that sells jewelry.”

  • Fraud probes: In addition to its financial problems, Friedman’s is in legal hot water. In January 2005, the attorneys general of Texas, Florida, and Tennessee each filed consumer-fraud lawsuits against Friedman’s, alleging that the chain pressured low-income customers to sign up for loan-protection insurance without disclosing the cost or explaining that the insurance was optional. The Department of Justice and the SEC have also been investigating the company since 2003 on allegations stemming from its relationship with a former vendor, Cosmopolitan Gem Group. Friedman’s former CEO, Bradley Stinn, and former chief financial officer, Victor Suglia, left the company amid suspicions concerning the investigation. The potential consequences of an SEC action against Friedman’s are “a wild card that nobody has addressed,” says Gassman.
    “We don’t comment on the progress of investigations, other than to say that Friedman’s is working cooperatively with federal and state regulators,” says attorney Butler.

Effect on Suppliers

In a rapidly consolidating industry, what will happen to the manufacturers who have been supplying Friedman’s with goods?

James Shein, a bankruptcy attorney at McDermott, Will & Emery in Chicago and a former turnaround consultant, notes that suppliers might feel effects in three areas. “Number one, if they haven’t been paid, they end up with an unsecured claim,” says Shein, who also teaches at Northwestern University and is the vice president of university relations for the Turnaround Management Association. “If the company doesn’t reorganize, the unsecured claim could be worthless. Even if the company does reorganize, it could be worthless,” since secured lenders take priority in repayment.

Second, Shein says, under the bankruptcy code, payments made to creditors within 90 days of the bankruptcy filing—known as preference payments—can be required to be returned to the debtor so that no one creditor benefits over the others.

Third, according to Shein, when a large retailer like Friedman’s gets into financial difficulty, “The remaining big guys are even more powerful, since there are fewer players left.”

JBT’s Kenyon notes that since the 1990s’ wave of jewelry-chain bankruptcies, suppliers have adopted sophisticated strategies to protect themselves, such as special trusts for memo goods. In some cases, she says, the manufacturers’ banks insisted on the use of these tactics. Even so, Kenyon says, suppliers with small capital bases that rely more on bank debt than on their own equity can be harmed by the bankruptcy of a large customer. “There’s no question that Friedman’s bankruptcy is going to hurt some folks,” she says.

“If you’re a little guy, and Friedman’s is in your top-two customers,” says Davidowitz, “I think you’ve got a problem.”

Yet even the major suppliers who serve on the creditors’ committee are limited in their ability to negotiate, says Shein. Committee members, he explains, “have more say-so, know everything that’s going on, and can help shape the reorganization plan or even the payment plan, within limits.” But while members of the creditors’ committee are able to negotiate, they cannot negotiate solely for their own benefit. “The law says that everybody in the same class of creditor, large or small, must be treated equally. So you’re helping everyone in your class, not just yourself.”

“My guess is that Friedman’s bankruptcy will have less of an impact than Service Merchandise because of the magnitude,” predicts Ken Gassman. The chain once claimed to be America’s top mass-market jeweler.

Will the trade continue to ship to Friedman’s? “Creditors need to have the information to satisfy themselves that the company has the ability to repay the debt and remain a viable retailer,” says Kenyon. She says suppliers would consider continuing to do business with the chain “if things are perceived to have changed there: if there are visible changes in management, if there is transparency in the reporting of financial information, if they have a good plan that they’ve shared with the trade.”

Displaced Employees

Friedman’s March 28 8-K filing says its new business plan “entails offering a consistent, pleasant, and productive shopping experience created by guest-focused, highly motivated, and knowledgeable sales associates. As part of this program, Friedman’s is implementing a number of associate initiatives to attract, develop, and retain the best people possible and provide them with the tools, training, and incentives to be successful.”

As the chain shuts down underperforming locations, associates who wish to continue in the jewelry industry will reenter the employment market. According to Kimberly Northup, career services manager at the Gemological Institute of America, about a third of the 600-plus jobs posted in GIA’s database are retail sales positions.

Would a displaced Friedman’s employee be a good fit at another retailer? “People get excited about jewelry experience,” cautions retail sales consultant Kate Peterson of Performance Concepts, “but a responsible retailer would need to look at those people as they would look at anyone with any kind of experience. I would not rule out one of these employees out of hand, but the worst thing retailers can do is assume there are skills there based on certain levels of experience.”

Suzanne DeVries, president of Diamond Staffing Solutions in Derry, N.H., has been interviewing Friedman’s employees seeking other jewelry employment. While some candidates were trained to sell credit rather than jewelry, DeVries says, she has also found outstanding people who are now doing well in other chains, including several former Friedman’s regional managers.

“The best people will rise to the top,” DeVries says. While some former Friedman’s workers are deficient in their product knowledge, she says, “The best ones have a passion for retail, they have a passion for the business, and a great work ethic. And they are very, very trainable.”

Peterson suggests that jewelers interviewing candidates with chain- or discount-store experience ask the applicants to describe the culture of their former workplace to glean what was expected of them and what it meant to do a good job in that environment. “I want to know what they didn’t like,” she says. “The ones who are challenging ‘Just do what I say’ are the ones you want. The people who look beyond what’s handed to them are the ones who will make your business better. It would be a mistake not to look at them; they may have some customer insights.”

At the same time, Peterson says, candidates “have to look in the mirror and recognize what they have versus what they don’t have. They have to ask themselves, ‘Am I willing to invest in learning what it takes to function in another environment?’ It could be a good fit if everyone on both sides would make a commitment to train and to learn.”

Competitive Edge?

Does Friedman’s bankruptcy give the chain’s competitors an advantage? Savvy competitors will try to capitalize on the uncertainty resulting from Friedman’s Chapter 11 status, says David Auchterlonie, CEO of the Scotland Group, a California firm that assists underperforming and distressed businesses. But Auchterlonie, a past chairman of the Turnaround Management Association, notes that Chapter 11 is less of an issue for customers than it was 10 years ago. “It’s become less of a black eye. More and more people understand that it is, unfortunately, part of the life cycle of many companies.”

Friedman’s bankruptcy filing does not mean that others in its market segment are likely to follow suit, notes Ken Gassman. “Personal bankruptcies are down, the debt burden for consumers is down, and the ratio of household wealth to household income is up,” Gassman notes. “That is a positive scenario for low-end credit jewelers.”