Special Situation - Friedman's (FRM) - Long - 2.5% Position
The following is my original research:

Business
Friedman’s is the country’s third largest retail jeweler. The company operates over 700 stores primarily throughout the Southeastern United States and California. FRM’s stores are located primarily in shopping malls and retail strip centers. The company targets low to middle income consumers.

The Story
Friedman’s is a company in distress. The best way to understand what is going on in with the company is a time line of its recent missteps.

•7/21/03 – Company cuts estimates for 2003 from $1.42 - $1.45 to $1.38 - $1.30.
•8/29/03 – Announces plans to sell 2.5 million shares of stock in a secondary offering.
•9//2/03 – Company raises guidance for 2004 to $1.70 - $1.80 from $1.55 - $1.75.
•9/12/03 – SEC opens an investigation into Friedman’s and 13 other jewelers. The investigation is in regards to a lawsuit filed against the group by Capital Factors, a receivables factoring company. The suit alleges that the defendants helped Cosmopolitan Gem (a Capital Factors client) misrepresent its accounts receivable. The plaintiff is seeking at least $30 million in damages from the defendants.
•9/19/03 - Company sells 3.1 million shares of stock at $15 per share.
•10/2/04 – Freedman’s announces for September Quarter. Sales were up 8.8% to $74.5 million from $69.2. Same store sales increased 3.4%.
•10/23/03 – Company postpones 4Q results, sites Capital Factor investigation as reason. Company also states that there will be no delay in filing its 10-K.
•11/11/03 – Friedman’s announces an increase in their Allowance for Doubtful Accounts to 14%-17% from their previously stated guidance of 10.5%. This change is expected to result in a $.23 to $.45 non cash charge. The company also put the CFO on a leave of absence, and the SEC and Justice department expanded their investigations to include this latest revelation.
•11/17/03 – Class action suites are filed.
•11/17/03 – Company says it will restate 2000 thru 2003 results, Ernst and Young withdraws its audit opinion on all prior filings, and the company states that allowance for doubtful accounts may exceed 17%.
•12/8/03 – New CFO from E&Y’s restructuring division hired.
•12/29/03 – Company misses last day to file 10-K, and says it expects to file the 10-K by the end of February 2004. Friedman’s is now in default on ~ $150 in debt, but is working with its lender.
•1/7/04 – Friedman’s announces December quarter sales results. Sales for the quarter were up 6.3% to $210.6 million from $198.1 million. Same store sales increased 2.7%.
•2/27/04 - Friedman’s announces February (Valentines Day) SSS results. Same store sales for the month were up 5.6%. The company also announced plans to close 50 to 65 stores in the next six months (out of 714 stores). Additionally, Friedman’s announced a delay in releasing their 10-K and 10-Q citing the valuation of the “Allowance for Doubtful Accounts” account and other areas that will be adjusted including inventory, AP and accrued liabilities.
•3/15/04 – Company announced that E&Y resigned as independent auditors of Crescent Jewelers.
•3/25/04 – Friedman’s is notified by the SEC that it may be sued over its accounting and financial reporting practices.
•4/13/04 – The Chairman of Friedman’s audit committee passed away. David Parshall, an outside director, is appointed head of the audit committee.

Commentary
After reading Friedman’s financials and supporting documents the question I kept asking is whether Friedman’s is in a broken business or the company has a broken business model. I feel like the company’s business model is flawed and must be changed if the company expects to prosper. With that said does the stock make a good investment? Well get to that in a second, but first let’s talk about the business model.

Where to begin. The flaws in Friedman’s business model have been exposed by a weak economy and a leveraged consumer. Namely:
• Credit Sales - 53% of Friedman’s sales are on credit. The company has extended credit to 396,001 customers who carry an average balance of $446. The outsized use of credit and the means by which the company extend credit is fundamentally flawed for a company this size. First the company states’ “Our credit programs allow our customers to purchase more expensive and larger quantities of our merchandise…” Or to say it another way our credit programs allow our customers to buy what they can’t afford. I’m not against credit per say, but to bet over half of your sales on the ability of lower income/marginal consumers to pay is not a sound business practice. The second flaw in Friedman’s credit sales strategy is where the decisions are made. Credit decisions are made at the store level, not at the corporate level. This may of worked when the company was smaller and senior management could spend more time on store level issues, but with operations spread across the country, ensuring that store managers are only extending “good credit” is not something I believe the company can realistically handled. My last point on credit sales - why hasn’t Friedman’s outsourced credit operations to someone like CitiBank or GE? Zales and many other retailers do.
• Growth – Friedman’s has grown from 55 stores in 1998 to over 600, and if you add in the Crescent stores to over 700. Growth is a good thing, but uncontrolled growth only magnifies business flaws.
• Store Location – The Company t locates its stores in “power strip malls” near Wall Marts, Targets etc. I really can’t fathom why you would locate a low end jewelry store next to the nation’s largest jewelry seller, i.e. Wal Mart. It allows your consumers to easily comparison shop your products, and it most likely forces price competition in an industry that for all intents and purposes is a commodity (gold is gold, regardless of where you buy it).

Positives
• The jewelry business is a good business. It is a business in which the customer typically has little knowledge, the inventory is easily valued, and customers are willing to pay a premium for high touch customer service.
• Friedman’s has halted store growth and expects to close 50 to 65 stores. This should slow down their cash burn.
• The September 2003 secondary raised $43.2 million (after estimated selling concession). Hopefully the company hasn’t spent it all, and can use the cash to shore up the balance sheet, ensure a steady supply of inventory, deal with the problems at Crescent, and keep the creditors happy.
• While I never like a “B” share controlling structure, at least management has a vested interest in ensuring the company is a going concern. If we’re wiped out Cohen (the controlling shareholder) is wiped out too.
• The only news I have seen concerning the debt is related to “covenant issues”. Thus, the creditors may try and extract an extra pound of flesh, but not push the company into bankruptcy.


Negatives
• The lack of financials is obviously a huge concern. Basing decisions on data that is over nine months old is not ideal.
• What will happen to accounts receivable, or how “real” are the sales. This the KEY question.
• The September stock sale preceding the November investigation/lawsuits is troubling. I think the company may have a hard time explaining that they did not know about the A/R issues at the time of the stock sale, giving the lawsuits more credibility.
• The company is pushing the NYSE listing requirements. If they don’t file soon they may end up on the Pink Sheets.
• See business issues above.

Valuation
Friedman’s currently has 20.755 million shares outstanding, at a $5.90 stock price that equates to a $122.45 million market capitalization, add the bank debt of $130.2 and subtract out the cash of $355 thousand and you get an enterprise value of $253 million (Note: I used the consolidated Friedman’s and Crescent financials from the September S-1). To get a fix on what the stock should trade for we first need to determine if the company is going bankrupt.

First, per the S-1 Friedman’s covenants are as follows:
1. Consolidated leverage ratios must not exceed 2 to 1
2. Consolidated adjusted tangible net worth, must not be less than the sum of $140 million. Each fiscal period thereafter net worth must not be less than the sum of $140 million plus 50% of consolidated net income plus an amount equal to 75% of equity transactions.
3. Consolidated fixed charge coverage ratio for the proceeding 4Q must not be less than 1.15 to 1.
4. Retail sales must be within 70% of projections

Second, from Friedman’s November 11th & 17th press releases:
1. “Based on information currently available, the allowance is expected to be in the range of 14% to 17% of accounts receivable outstanding as of September 27, 2003, compared to the previously disclosed expectation of 10.5%. However, this estimate is subject to further adjustment based upon the completion of the Company’s analysis and Ernst & Young’s audit of the Company’s financial statements. Assuming this allowance is included in the operating results for the year ended September 27th, 2003, the company would incur an additional non-cash charge (net of taxes) ranging from approximately $.23 to $.43 per share.” Six days later, on the 17th of November the company said,”…Based on the most recent information available, the Company now believes the allowance may exceed 17%.”

Now putting what we know together I think we can get a rough sense of how large of restatement is needed to push Friedman’s into insolvency.
1. On a consolidated basis, Friedman’s has $281 million ($13.56 per share) in equity (book value). The September share sale increases Equity to $324.5 million ($15.63 per share). In terms of debt Friedman’s has $24.5 million in accrued liabilities, $42.6 million of the bank debt is “current”, and the company has $130 million in bank debt and other liabilities; for a grand total of $197.1 million. Thus, defining the leverage ratio as total debt to total equity, Friedman leverage currently stands at 61%, well below the 2 to 1 cap. Assuming that liabilities stay will stay roughly constant in the restatement, and book value will be affected by the write-down, then Friedman’s can withstand a write down in book value of $225 million, which is significantly above the company’s previous guidance.
2. The current book value “floor” stands at $140 million plus $32.4 million (equity issuance x 75%) or $172.4 million. On this measure Friedman’s could write down book value by $152 million.
3. Friedman’s and Crescent’s combined interest expense over the three quarters preceding the S-1 filing was $7.5 million. Estimated full year’s interest expense is $10 million. Thus for Friedman’s to violate the third covenant, its EBIT would have to fall below $11.5 million. Estimating EBIT historically is problematic because, prior period financials are for Friedman’s only, prior to the S-1 Friedman’s had accounted for Crescent as a minority interest and did not consolidate. If I had to guess I would say Friedman’s can exceed the 1.15 to 1 ratio.
4. Having no insight into what sales projections Friedman’s gave the banker, any attempt to estimate if the company meets this covenant is nothing but a guess. One piece of antidotal information, on a recent visit to my local Friedman’s the company is still pushing credit sales in the store and in its circular. Again, while not the best business practice I believe it will allow the company to fulfill this covenant. If they had pulled/reduced credit sales I would be worried.

In summary, with the information I have I do not believe the company will be forced into bankruptcy. Now with the bankruptcy concern alleviated, we need to determine what the stock is worth – a tough task. Using historical ratios is problematic because we’re not certain the financials they are based on are real. Regardless, it is a place to start. As of April 15th 2004 Friedman’s is carrying the following ratios (per Bloomberg/Stockval):
Ratio Current 5 Yr Avg. % Difference
P/E 4.08 6.4 +57%
P/Book .36 .6 +67%
P/Sales .24 .32 +33%
P/EBITDA 2.02 3.2 +58%

If Friedman’s isn’t the cheapest stock in the market it’s close. If we assume a worse case scenario and double the previous disclosed expected write down of $.43 per share in book value ($9.3 million) we get a write down of book of $18.6 million. New book value would stand at $305.9 million. Applying a .6X multiple to the new book value you arrive at an equity value of $183.54 million or $8.84, an upside of 50%. I do admit relative valuation leaves a lot to be desired, but I do think it highlights Friedman’s cheapness.

Another way to value the company is relative to its liquid current assets, or what you would get by buying the company in the market, paying all the liabilities and selling the assets. If you assume that cash is cash, inventories can be liquidated at 100%, you take a drastic 50% haircut to A/R, and all other assets are worth zero and you can buy the company for $122 million (at current stock prices). Then you should be able to earn 45% after liquidation. This simplified analysis leaves out the possible upside from the $45 million stock sale and any value from the “long term” assets. It also does not take into account the “B” shares. While not perfect the liquidation valuation is conservative and leaves room for error.

Conclusion
I believe the “worst case scenario” is more than priced into Friedman’s stock and a long position in Friedman’s is warranted. To be short the stock you have to think bankruptcy is right around the corner. I do not. A couple of final points to wrap up with:
• Sales reports for the past few months have been positive.
• An improving economy will help the company’s credit collections (witness the April Jobs Report).
• The company is closing stores and conserving cash.
• The stock is dirt cheap, with rock bottom expectations – a perfect scenario for positive future performance.



- posted by Bobby D @ 12:48 PM

 
Building the Research Bullpen...
I figured the best way to kicked off my research efforts is by starting a bullpen of ideas, and start to write about them daily. These ideas have already passed the first test, they've got me interested. What I plan on doing in this blog is drilling down deeper and start to do the research required to make an investment. I will try and write 3 days a week on a topic out of the bullpen, also I will update the bullpen as new ideas come on the radar screen.

Where do these ideas come from? Lots of places - the newspaper, stock screens, other investors, newsletters, trade pubs,bloomberg etc.

The bullpen:
CAW - CCA Industries
JOE - The St. Joe Company
DHB - DHB Industries
BRO - Brown and Brown
FDS - Factset Research
ASR - ASUR (airport operator)
STMP - Stamps.com
Various Oil and Gas Names (esp Drillers & Producers)

all for now....


- posted by Bobby D @ 1:44 PM

 
Two interesting websites
Just wanted to call your attention to two sites I found while surfing. The first site can be found here. It is a blog kept by a HF manager that details what he is thinking. He/she seems to be very trading oriented, but it is relatively interesting none the less. The second site can be found here. This site is actually pretty cool, its a blog that writes about the latest and greatest in gadget news, lots of cools stuff, and you might even get a few money mking ideas.
- posted by Bobby D @ 1:00 PM

 
Its been awhile, but I'm still alive
I've been on the road the last two weeks, thus the lack of postings. I went to St. Louis to visit a grad school. I really liked the town, school etc. and will probally end up there. On a more interesting note, I attended an AIMR conference on Hedge Funds in Philly. It was relatively interesting from an "investor in HFs" standpoint, but as an actual HF manager the information was lacking. A couple of key points from the conference.
* Investing in and managing HFs is an art not a science - D. Sussman/Paloma Partners
* There are to many hedge funds out there (roughly 6,000), but from an institutional investors standpoint the main concern is capacity of the good funds.
* Relationships are EXTREMELY important
* Be careful of the HFs that have gone from managing money to gathering assets.
*The best returns are had at HFs with $10M to $200M in assets
*A key to successfully investing in HFs is to understand the funds process and controls. Knowing the positions (i.e. transparency) doesn't do much good.
*Focus on finding the best TALENT and pay up for that talent, b/c in the end investing in HFs is not about picking the right asset class or style it is about picking the best people to run the money.

As a budding HF manager what did I learn from all this? First, network, network, network! Second, be able to define (and actually have) a competitive edge that is proven and repeatable. Third, passion for investing is key. All the manager who spoke were extremely bright, but the one thing that was a common thread in all their presentations was their passion for the markets and investing. Something I posses by the truckload.

- posted by Bobby D @ 1:56 PM

 
RBAK ...ad nausem
As I write this post the current spread in my RBAk setup is ~(4.85). I have lost my ass in this position since I first wrote it up. Call me crazy, or just plain stupid, at this point I am doubling up on the position. I still can't find any reason other than the short squeeze for this thing to be so out of line. My target price for the warrants is 6 bucks. This is based on an option valuation using an IV of 110%. If the warrants go to 6 and the stock stays where it is currently ($7.25) the spread will be trading at a +$1.25 which equates to a 144% return on the initial setup. By no means am I saying the stock will stay where it is. My bet here is that the warrant is overvalued, and should be trading under the stock. The warrant should trade for roughly 65% of the stocks value......patience is the key to success with this one....
- posted by Bobby D @ 8:44 AM

 
Rankings....
I subscribe to the doctrine of "KISS" (Keep it Simple Stupid). Thus with that in mind here is how I will rank things:

5%
2.5%
No Position Taken
-2.5%
-5%

What does this mean? A "5%" ranking means that in an equal weighted portfolio you should allocate 5% of your capital to this position, a "negative 5%" means go short with 5% of your capital.

That's all on the groundwork. From here on out I will be introducing the stocks and ideas I plan to research, and investment themes that can be exploited for fun and profit!


- posted by Bobby D @ 10:07 AM

 
Research Framework....
Since this blog purpose is to document the research process and investment ideas, I figured I need to lay some sort of framework such as a buy/sell/hold and timeframe for the investment(s). What I don't want to happen is to come out with a full blown research report every time I write about a new idea. Research is an ongoing process and when I feel I have all the facts I need to make an investment I will highlight that point in a post.

In terms of the investments holding period, I will highlight that when I make a recommendation. I don't want to come up with hard and fast rules on holding periods. I will make my initial recommendation on the holding period and as the situation progresses talk about what I see in terms of holding period going forward.

Alright, enough of me jabbering on....to ease your future use of this blog I will post the rankings next in a blog titled what else "Rankings".
- posted by Bobby D @ 9:41 AM

 
Questions, Questions.....
Since I have been out of the game of following stocks on a day to day basis for a while I decided to sit down and think back over all the research I have done, and research I have seen and come up with a list of questions that, I think, when answered go a long way towards deciding if the particular situation is a buy/sell/hold/or short. By no means is the list exhaustive, or for that manner complete. I figured as a "generalist" there are certain questions that apply to all investments and are a good springboard for further research. Also, as a generalist it is sometimes hard to define your "process" and being methodical in your research is one of the keys to success. Anywho, here comes the list:

* What does the company do?
* What is the company's competitive advantage?
* What are the catalyst to unlock value (for shorts - destroy value)?
* Has management been buying or selling stock? How much? When?
* What is your downside in the stock? How did you calculate the downside?
* Who are the company's customers? What is the customer's financial health? What could change the customer's financial health?
* What are the industry's competitive dynamics? Should we pull our hair out worrying about the competition? Why? Why not?
* Does the ultimate success or failure of the investment depend on a theme? What theme? What is the market's expectation for the theme? What's yours?
* How does the street value the stock? P/E, DCF, Relative Valuation etc...?
* What is the street expecting for the next 4Qs? What does this imply for margins, sales growth, market share, pricing etc?
* How has the stock performed over the last year/6 months/ 3 months? Have there been any big moves? Why?
* Is the stock the best risk/reward? Should we look at their debt? options?
* Is management credible?

All the above questions generally fall into one of 5 broad categories - valuation, competitive position, growth prospects, catalyst & macro drivers.

Finally, you can never forget that you are paying for a future stream of earnings, thus a valuation analysis is EXTREMELY important.

All for now....





- posted by Bobby D @ 1:59 PM

 
More on Redback
Just got around to reading barrons tdy. The redback situation was mentioned in the Trader Column. Basically the gist of the mention was can you believe this?. One interesting tidbit was the fact that part of the misvaluation may be do to a short squeeze. For those players who were short the stock prior to bankruptcy they are being asked to deliver not only the stock but also the warrants to cover their shorts. Thus the runup. Also, this thing has been all over the place, and has a spread you could drive the 1st Calvary through! As of yesterday's close the position had a value of -$2.85, it opened up 41% traded all over the place and now is down twenty percent. Go Figure. Still think as time passes the warrants should return to some semblance of fair value, so hold on the ride may be wild!

One last thing, they just opened RBAK options on the Philly, while none have traded yet they are quoted at an IV of around 80%, well below the IV of the warrants. Makes you wonder....
- posted by Bobby D @ 11:02 AM