Description

Friedmans (FRDM) 08/24/04, $1.60

Due to an extreme overreaction by the investment community, Friedmans is ridiculously cheap both on an earnings and on a liquidation basis. The company, which has not filed financials with the SEC in a year, is currently in the midst of a turnaround and restructuring. In fact, extensive channel checks, which include speaking with three regional managers covering three dozen stores as well as multiple individual store checks, have found that same store sales have been up across the board ¡V in some cases for thirteen straight quarters. At the corporate level, the company recently hired a new seasoned management team who, with the Zolfo Cooper (a highly regarded restructuring firm), are working with the creditors and vendors to stabilize operations. The issues will be resolved and when that happens, the company should trade more in line with its peers, which is over eight to ten times the current stock price.

FRDM is currently trading at levels well below liquidation value; the market obviously believes the company is bound for something worse than bankruptcy. In reality, while the company may file bankruptcy for efficiency purposes [closing underperforming stores, etc.], the company is no where near liquidation and in our estimate is trading at under 50% of liquidation value.

Description:
Friedmans is the #3 retail jewelry chain in the US (behind Zales and Sterling Jewelry) targeting the low end, credit sales segment. The company has grown from 55 stores in 1992 to over 700 stores in 2004, covering 20 states primarily located in the Southeast. About 2/3 of the stores are located in strip malls anchored by mass merchandisers such as Wal-Mart or Target while the rest are in regional malls. The company targets low to middle income consumers ($35K-$50K), ages 18-45 and primarily sells diamonds, gold, gemstones and wedding-related items. Credit sales, which account for about 50% of net sales, drive significant store traffic as most customers make credit payments in person. This allows sales associates to develop personal relationships with customers and facilitates an opportunity to up-sell additional purchases.

Due to accounting irregularities, an SEC investigation was started with the company in the summer of 2003. This development has caused no discernable store-level business disruptions, but did result in the significant dismissals at the management and board level, civil litigation, a [pending] restatement of the company¡¦s 2000-2003 financials, and a delisting of the company¡¦s shares from the NYSE. Further, the company has not made any filings with the SEC since the summer of 2003.

Despite these issues, the company has a solid business model and significant competitive advantages based on building direct relationships with customers through their retail store partners (or store managers) and sales associates as over 75% of customers, who finance their purchases, make payments in person at the store. Though 50% of its revenues are exposed to sub-prime lending risks, there is a high level of repeat customers, and same stores sales are doing well in the half dozen regions (as per regional and store level managers and salespeople). The company has also placed controls on the credit operations at the store level, which should dramatically improve the credit decisions and collections.

Industry
The US retail jewelry industry has grown to $45 billion in 2003 at a compounded annual growth rate of 5.1% over the past 20 years since 1983 (which was at $16.5 billion). Given the discretionary nature of consumer spending on jewelry, sales have been surprisingly consistent during the period, declining only twice. One reason is that approximately 1/3 of industry sales is related to bridal, which is stable during good times and bad.

The industry is highly competitive and fragmented with approximately 25,000 jewelry stores nationwide. It is divided into three buckets:
1) Specialty Retailers ($27Bn in 2003) ¡V consist of regional, national and independent mom and pop stores that are pure play jewelry stores. Major players include Zale Corporation/ZLC (which includes Zales, Gordon¡¦s and Piercing Pagoda operations), Sterling, Inc. (which includes Kay Jewelers), Tiffany, Helzberg¡¦s Diamond Shops (private), Friedmans, Whitehall, and Reeds Jewelers (recently sold to Zimmer family)
2) Department Stores/Mass Merchants ($12Bn in 2003) ¡V consist of major department stores including Wal-Mart, Sears, JC Penney, Finlay, Federated, Target, FredMeyer, etc.
3) Direct/Online ($6Bn in 2003) ¡V consist of QVC, Shop NBC, Home Shopping Network, Blue Nile, EBAY, etc.

Friedmans differentiates itself through its proprietary credit business generating counter payments in stores, producing recurring traffic and, in turn, incremental sales. The company also dominates the power strip locations (2/3 of its stores), which are anchored by a Target or Walmart. At these locations, Friedmans is often the only competitor, while many of it¡¦s mall-based peers have four or more competitors to contend with.

Store Model
Store economics are very favorable as it is profitable in first year in business

Malls Power Strips
Initial Investment: 1,200 ¡V 1,300 sqft 1,600 sqft
Inventory, net of payables $170K $140K
Leaseholds/assets 180 80
Average accts receivables 65 42.5
Total $415K $262.5K

1st yr 5th yr 1st yr 5th yr
Merchandise Sales $750K $1,100K $500K $750K
Store Contribution 15% 20% 16% 22%
Operating Income $110K $220K $80K $165K
Approximate ROI 26% 45% 30% 55%


Management:
The company hired Sam Cusano (6.22.04) as CEO and Steven Moore (6.29.04) as CAO and General Counsel. Sam has significant retail/jewelry experience as well as financial experience having previously worked as a CFO and CEO of Service Merchandise. He was appointed CEO of Service Merchandise during its restructuring when it was already too late for the company and it never emerged from bankruptcy. Steven Moore also comes from Service Merchandise serving in the same capacity.

Financials:
The company is highly profitable with fairly constant gross margins and increasing operating and net income margins; however, this will be revised downward based on restatement.

1998 1999 2000 2001 2002 2003E 2004E
Net sales $259.1 $308.4 $376.4 $411.0 $436.1 $468.9 $499.8
COGS 135.4 164.0 199.6 216.3 227.5 245.7 263.1
Gross Profit $123.7 $144.4 $176.8 $194.7 $208.6 $223.2 $236.7

SG&A 100.5 $110.7 $133.3 $160.9 161.5 167.9 180.1
D&A 5.3 6.4 9.5 13.9 11.3 12.6 12.6
EBIT $18.0 $27.4 $33.9 $26.4 $35.7 $42.7 $43.9

Net Interest 0.9 1.4 2.4 2.5 0.3 1.0 0.4
Income tax 6.5 9.5 11.8 6.6 12.4 14.5 15.3
Minority Int. 0.0 0.0 (0.3) (1.4) (0.2) 0.0 0.0
Net Income $10.6 $16.5 $19.7 $12.2 $23.2 $27.1 $28.3

EPS $0.72 $1.13 $1.36 $0.84 $1.34 $1.22 $1.27
EBIT $18.0 $27.4 $33.9 $26.4 $35.7 $42.7 $43.9
EBITDA $23.2 $33.7 $43.4 $40.2 $47.0 $55.2 $55.9

Margins
Gross 47.7% 46.8% 47.0% 47.4% 47.8% 47.6% 47.4%
EBIT 6.9% 8.9% 9.0% 6.4% 8.2% 9.1% 8.8%
EBITDA 9.0% 10.9% 11.5% 9.8% 10.8% 11.8% 11.2%
NI 4.1% 5.4% 5.2% 3.0% 5.3% 5.8% 5.7%

Restatement*

New EBITDA $11.3 $20.1 $28.8 $13.7 $26.5 $33.1 $32.3
Margin 4.4% 6.5% 7.6% 3.3% 6.1% 7.1% 6.5%

* Assuming an increase in the provision for doubtful accounts by 40% effectively increasing the allowance for doubtful accts by approx 22%


Valuation:
Friedmans is trading at a significant discount using a number of valuation metrics to Zales and Whitehall, the best public comparables available. Although, the company has historically traded at a discount to these firms, it has never been as severe as the current multiples. The company is currently trading at 0.1x Price/BV, 0.3x LTM EV/ Revenues and 2.2x LTM EV/EBITDA, 1.1x LTM P/E.

Stock Price $1.60
Shares Outstanding (Class A + B) 22MM
Market Capitalization $35MM
Net Debt $86MM
Enterprise Value $121MM

Assuming the company trades back in line with historical multiples after the restatement, the company should be in a range between approximately $6.5 and $9.5 depending upon which valuation metrics (e.g. 0.6x BV, 7.0x EBITDA, 0.6x revenues).

Risks to the investment:
Company¡¦s dual-class voting structure enables the one Class B shareholder, Phillip Ean Cohen, to elect 75% of the directors and have all other voting rights ¡V effectively leaving company control in one man¡¦s hands. He substantially controls all corporate actions, without any vote required by holders of Class A common stock, including, without limitation, amending the certificate of incorporation or bylaws (including to authorize more shares of Class A common stock), authorizing stock options, restricted stock and other compensation plans for employees, executives and directors, authorizing a merger or disposition of or change in control, approving indemnification of our directors, officers and employees (and related parties) and approving conflict of interest transactions involving affiliates.
* Analysis: while I do not expect that Mr.Cohen will relinquish his control, he is incentivized to act in a shareholder friendly way as he owns over 1MM shares. However, Mr. Cohen is also a controlling shareholder of EZCorp (Nasdaq: EZPW), which is also under SEC investigation. I do not know the financial situation of Mr. Cohen (e.g. he sold shares in EZ Corp due to a margin call at the end of May) and therefore cannot predict how he may attempt to use his control in the Friedmans as a vehicle to help him if he is in financial distress.

* The SEC investigation regarding overstatement of accounts receivables, materially false/misleading disclosures, etc. may find significant fraud.
* Analysis: the company has stated that it expects to increase the allowance for doubtful accounts by more than 17% and will therefore need to restate 2000-2003 financials. In my analysis, to be conservative I have assumed the allowance increases by approximately 25%.

* Quality of its credit sales ¡V There used to be few guidelines and restrictions on credit decisions at the store. I do not have an in-depth knowledge of the quality of those sales or the payment status for those sales.
* Analysis: the company has much stricter guidelines that were handed down in the past 6 to 8 months ¡V wherein the amount of credit store partners can offer customers is limited and is based on specific criteria (e.g. FICO score, verifiable work and home address and phone, etc.).

* General economic conditions (e.g. unemployment rate, wages, interest rates).
Analysis: Decreasing unemployment and increasing wages should help with collections as well as boost sales; however, an economic downturn will negatively impact the company similar to the levels in 2001 and 2002.

* Increasing interest rates should reduce margins on the subprime credit business, which is greater than 50% of sales.
* Analysis: the company currently charges the maximum interest allowed in each state in which it operates; however, this is still a very profitable business (i.e. charge 18-24% interest and borrow at 3-5%) and without a massive rise in interest rates, I believe that spreads on their lending business should remain quite high and therefore very profitable.

* Business model ¡V are 48% gross margins enough to compensate for potentially high credit defaults (potentially as high as 15%-20%) from its lending business, which accounts for approximately 53% of total revenues.
* Analysis: these gross margins are by no means insufficient to earn a profit in the current lending environment. For example, if the company sells an item for $100 on credit; the company¡¦s goal is to get paid in 8.5 months (accounts receivable days are about 7 months) including the interest payments. I have assumed a 15% spread (e.g. the company charges 18-20% interest and borrows at 3-5%), which means that the company will get approximately $109 after 7 months. Assume that the company¡¦s costs of goods sold are $52 (e.g. 48% gross margin), the company¡¦s profit is $57. Assume the company makes this 85% of the time and 15% of the time due to credit default, they lose $54.33 (which is $52 COGS plus $2.33 debt interest). Based on these assumptions, the company still makes a healthy profit of approximately $40.

* Litigation:
- Capital Factors ¡V alleging that the company along with Whitehall, Crescent and others helped Cosmopolitan Gem misrepresent its accounts receivables; seeking min. $30MM
„« Analysis: I believe that the Capital Factors litigation has been settled for $5M.

- Wells Notice received (3/24/04), the SEC staff is considering recommending that the SEC bring a civil action alleging violations of U.S. securities laws
* Analysis: the previous management team is no longer with the company; however, they were appointed and affiliated with the controlling shareholder. I believe that the new management team from Service Merchandise is not affiliated with the controlling shareholder, however, I cannot be certain.

- Default risk on $126.6M debt (6/28/03) due on Aug. 28th, 2005; The debt has an average interest rate of 3.5-4.3% and some financial covenant requirements
* Analysis: I do not believe the company is violating any financial covenant requirements. The company may technically be in default by virtue of their restatement of their financials, however, the banks continue to allow the extension of credit at the store level. In the worst case scenario of liquidation, I believe that equity shareholders will be able to recover a substantial portion of their investment at these levels

- Loss of key vendors ¡V the company has deferred most current payments to vendors over the last 60 days and key vendors have reduced, delayed or suspended merchandise shipments
* Analysis:the company recently announced a commitment for additional financing of $25-30MM which would be used to pay its vendors. Primary research confirms that vendors will begin shipping again once they receive payment.

- Lack of financial data ¡V 2000-2003 is being restated; no reported financials since June 2003
* Analysis: In my analysis I use significantly lowered 2000-2003 EBITDA numbers (in comparison to what mgmt has guided) to project 2004.

- Risk of impairment on $50MM Crescent equity investment; risk of Crescent default on $36.3MM senior unsecured notes it owes Friedmans
* Analysis: Crescent has filed for Chapter 11 bankruptcy; in my liquidation analysis, I have assumed that the FRDM¡¦s equity is worth zero.

- E&Y (Auditors) could resign ¡V but have not done so yet ¡V despite resigning from Crescent, a company closely affiliated with Friedman¡¦s
* Analysis: This is unlikely because E&Y resigned from Crescent back in March and probably would have resigned from FRDM as well if the issues were material ¡V but this is only an assumption.

- Relationship with Crescent - there is a belief that the Class B shareholder, who is also a controlling shareholder of Crescent, used his personal assets as a guarantee and when Crescent did not perform, used his control in Friedmans to save Crescent. Also, because both companies had the same management and backoffice, I am unsure if there are any issues with the financial reporting
* Analysis: this is may be the largest risk in our estimate; however, I believe that E&Y would have resigned in March if this was a big issue.

- Locations ¡V many of the locations are in enclosed regional malls ¡V a potentially dying shopping venue as more independent specialty stores in strip centers become more prevalent. This could limit foot traffic. Also, these leases tend to be longer term in nature and many have been signed in the last five years.
* Analysis: mall traffic is sensitive to the general economy, but it is not dying today or tomorrow. Going to malls is still an event for the family and I see foot traffic dying a rather slow death.

Catalyst

Catalysts:
* Successful financial restructuring of credit facility leading to resumed vendor support
* Filing of restated financials for 2000-2003
- Analyst will begin to write on the company again
* Relisting to NYSE
* Releasing of same store sales numbers (last release was as of 2/22/04 up 5.6%)
* Refined strategy and operations will lead to better future financial results. Kroll Zolfo Cooper, an established restructuring specialist hired on 5/26/04, will help management employ better practices including tighter lending controls and better general business practices
* Relationship with Crescent better defined and separated
* Settlement of litigation with Capital Factors
* Ending of the SEC investigation and filing of all required financials to date
* New CEO will unveil strategy
* Securitization of receivables will show the markets that their lending practices are more in line with sub-prime lending standards. This should add legitimacy to the company¡¦s lending standards and reduce its cost of capital.
* Appointment of a new, experienced CFO ¡V previous one resigned in May 04 [after his hire in Dec. 03]