Description

Note: Initial work on FNLY done by Andrew109 on 10/11/2001. This is a follow up

Investment Thesis

Finlay Enterprises (FNLY) operates over 1,000 jewelry departments in major department stores such as Robinson-May, Lord and Taylor, Dillard's, Bon Marche, Bloomingdale's.

With a market cap of $140M and consistent FCF generation of $20-$30M, FNLY trades at a FCF yield of between 14-21%. FNLY can continue to generate this FCF without having the benefit of 1.) Store growth, or 2.) Improved comps. In other words, just by paying down debt, you can expect the stock to appreciate least 15% per year by owning this company. This assumes no increase in valuation multiples (EV/EBITDA-Cap Ex currently at 6.7x). See the current valuation below.

Price: $14.78
Shares Diluted: 9.5M
Market Cap: $140M
Debt: $286M
Enterprise Value: $426M

2003 EBITDA $77M (5.5x)
2003 EBIT: $60M (7.2x)
2003 EPS $2.36 (6.3x) excluding $0.10 charge
2003 EBITDA-Cap $64M (6.7x)
2003 OCF-Cap ex $24M (16% FCF Yield)

Note: 2003 numbers are estimates for year ended Jan FY2004.

The key risk is debt: FNLY has average debt of over $280M on EBIT of approximately $60M and EBITDA of about $77M.

Assuming that the company continues to pay down debt and benefits from an improving economy and improving comps at host stores, it would seem reasonable that valuation multiples could expand, and an investor could double or triple their money over the next three years.

See potential valuation in 3 or 4 years below.

EBITDA-cap ex: $70M
Multiple: 8x
EV $560M
Debt $200M
Market Value $360M
Shares Outstanding 9.3M
Stock Price $39.00

As mentioned earlier, even without any increase in stores, sales or valuation multiples, an investor should still expect to make a healthy 15% return each year simply though debt paydown.


Key Catalysts

1.) Valuation: At FCF yields of 16-20%, this stock is just cheap. As cash is used to pay down debt (as well some incremental share repurchase), the benefit should go to the equity holders.

2.) Improving sales trends: FNLY's host stores (particularly FD) are expecting to show improved comps. As we approach the holiday season, FNLY should benefit if these comp trends hold.

3.) Continued Share repurchase: Steadily repurchasing shares 300K to 600K shares per year (3-6% of outstanding). Continued repurchase may be a catalyst.


Description

Finlay Enterprises (FNLY) operates over 1,000 jewelry departments in major department stores such as Robinson-May, Lord and Taylor, Dillard's, Bon Marche, Bloomingdale's. Overall, MAY, FD, SKS, and DDS respectively make up 47%, 23%, 12%, and 6.5% of Finlay's "host" department stores. This consists of all of MAY stores and 1/3 of Federated stores (all FD stores other than Macy’s). The remaining 11-12% consist of independent or legacy department stores (Gottschalks, Marshall Field). Department stores often choose to use FNLY rather than run the department themselves, because FNLY can provide higher returns to the host.

Although this was company was already recommended to the investor club in October 2001 at less than ½ of the price ($6.25), I still believe that the valuation at $14-$15 remains very compelling relative to the fundamentals of the company. I also believe that the company will benefit from improving sales trends with its "host" companies.

Valuation

Price: $14.78
Shares Diluted: 9.5M
Market Cap: $140M
Debt: $286M
Enterprise Value: $426M

2002 EBITDA $81M (5.3x)
2003 EBITDA $77M (5.5x)

Cap Ex: $13M (assuming all maintenance since openings offset closings)

2002 EBIT: $63M (6.7x)
2003 EBIT: $60M (7.2x)

2002 EPS $2.42 (6.1x)
2003 EPS $2.36 (6.3x) excluding $0.10 charge
2004 EPS $2.26 (6.5x) including $0.35-$0.40 less income from Federated

2002 EBITDA-Cap: $68M (6.3x)
2003 EBITDA-Cap $64M (6.7x)

2002 OCF-Cap ex: $29M (21% FCF Yield)
2003 OCF-Cap ex $24M (16% FCF Yield)

Notes on Valuation

To be conservative, I have adjusted the debt upward to reflect the seasonal nature of the business. (The company generates virtually all of its earnings and cash flow in the 4th quarter).

As of the end of 2002, the company had net debt of $156M consisting of debt of $225M (long term bonds) and cash of $69M. However, I have not deducted the cash from enterprise value because this cash is immediately used to pay off vendors just after year-end. Throughout most of the year, the company only has a few million dollars worth of cash on hand. Additionally, the company has a 225M revolver, with an average of $61M outstanding. My $286M debt number reflects $225M of long-term bonds plus $61M average revolver. The calculated valuation that you might find elsewhere likely reflects a lower amount of debt and thus, a cheaper valuation. I have chosen to be more conservative.

Even with my more conservative valuation, the company appears to be very cheap based on almost any metric (FCF, EBITDA-Cap Ex, EPS).

This company may be cheap for a good reason

1.) Lack of growth in "host" stores: FD, DDS, and MAY have been trimming rather than growing stores over the past several years. Off the mall apparel retailers (Kohl's), hardline retailers (LOW, HD), and discounters (WMT, TGT) have been stealing traffic away from malls with more convenient locations. Specialty retailers have been stealing traffic within the mall with better merchandising and more helpful customer service. The result has been declining SSS in "host stores" that have ranged from 3-5% over the last 2.5 years. Very recently, MAY decided to divest 34 stores which will negatively impact FNLY by about $0.10 EPS in 2003. See recent comp trends below.

2001 2002 1H 2003
FD -5.3% -3.0% -3.1%
MAY -4.4% -5.3% -3.1%
DDS -5.0% -3.0% -5.0%

2.) Department stores can choose to run their own jewelry centers: Instead of using FNLY, department stores can choose to run their own departments. At FD, FNLY operates the jewelry departments in Rich's, Lazarus, Goldsmith, Bloomingdale's, Bon Marche, and Burdines, but not in Macy's. Recently, FNLY lost 46 "host" stores as FD has decided to consolidate Burdine's stores into Macy's. This will negatively impact EPS by $0.30-$0.35 in 2004.

3.) High leverage and seasonal dependence: As a result of a leveraged buyout in 1993, FNLY has a lot of debt, relative to operating income. With EBIT/Interest at 2.5x and EBITDA/Interest at 3.4x, there is not a lot of room for error. Given the seasonal nature of its business, FNLY generates roughly 125% of its earnings and over 400% of its operating cash flow in 4th quarter. With the amount of debt load, an investor might worry that one bad Christmas can put the company into bankruptcy.


Addressing the risks

Trends improving at "host stores"

1.) SSS trends at FNLY are consistently better than at the host stores. As previously indicated, over the last 2.5 years, SSS have been down between 3-5% at the host companies whereas FNLY has had SSS range from +1% to -3%. The fact that the company can consistently drive comps at 2-4% ahead of its host stores allows them to achieve SSS growth even with flat comps at the host stores. FNLY comps have consistently matched their competitors (Zale's and Whitehall's), rather than their host stores.

2.) SSS trends at host stores are showing improvement. In the 2nd quarter, FD and MAY posted comp declines of 1.2% and 3.1% respectively, which is a significant improvement over the prior year (FNLY showed a positive 2.6% comp). For the second half of the year, FD expects to generate comps that will range from -1% to +1%. In August and September, FD and MAY have already posted comps of flat to +3% (with FD doing a little better than MAY). As the economy continues to improve, FNLY sales should benefit from the improved comps at the host stores.


Working capital advantage of the leasing to FNLY vs. In-house

1.) FNLY has indicated that they generate a higher return for their hosts than the hosts can generate by running jewelry in-house. By avoiding working capital investment typically required of running a jewelry business, host stores can improve their return on investment. On average, 50% of FNLY merchandise is carried on consignment.

2.) MAY, which represents about 47% of their business, has said that they will never run their own jewelry business. They believe it requires an expertise that they do not have. MAY also has indicated that jewelry has been one of their strongest performing categories. They have used FNLY for the past 20 years and have no plans to change them. MAY believes that the only reason why FD runs their own departments in Macy’s is that Macy’s had an expertise in the category when FD acquired them



Consistent cash flows, large revolver, long term debt give FNLY surprisingly strong liquidity

1.) $225M of Long Term Debt: $150M Notes Due May 2008, $75M Debentures due May 2008. 5 years before debt has to be paid down or refinanced.

2.) FNLY has a $225M revolver: Maximum amount outstanding in 2002 was $111M. Must only be paid down to under $50M by the end of the year. $0 outstanding at the end of each of the last two fiscal years.

3.) Consistent cash flow generation: Business generates between $20M-25M of FCF each year. Cash has been used generally either retained so that reliance on the revolver is reduced (Maximum revolver used was as high as $155M).

4.) 99% of lease payments are contingent on sales. So operating leases are really not a huge liability for them

Other Positives

1.) Share repurchase: The company uses FCF to repurchase stock. Over the last 2.5 years, the Company repurchased a total of 1.6M shares for $17 million, reducing outstanding shares by 10%.

2.) Focus: Rather than trying to rapidly by establishing new hosts, the company has been focused on improving their core business by improving working capital, reducing costs, and increasing departments within the host base.

3.) Low fixed costs: As a lessee, FNLY avoids substantial capital investment typical of standalone retail formats.

Catalyst

Key Catalysts

1.) Valuation: At FCF yields of 16-20%, this stock is just cheap. As cash is used to pay down debt (as well some incremental share repurchase), the benefit should go to the equity holders.

2.) Improving sales trends: FNLY's host stores (particularly FD) are expecting to show improved comps. As we approach the holiday season, FNLY should benefit if these comp trends hold.

3.) Continued Share repurchase: Steadily repurchasing shares 300K to 600K shares per year (3-6% of outstanding). Continued repurchase may be a catalyst.