Did Whitehall’s sale to an investor group earlier this month save the company from bankruptcy? Not only did Whitehall’s management warn earlier this year that the company “would be forced to file a bankruptcy petition” if it was unable to consummate a financial transaction, but our financial analysis also suggests that the company was plummeting into a financial abyss from which there would be no escape other than bankruptcy.

 

In early June, Whitehall agreed to sell out to an investment group for $1.60 per share. While this represented a premium over the recent market price, it was both well below the company’s historical trading range as well as below an informal offer – in the range of $7.00 per share – received in 2005.

 

Challenges Galore

In its final filings prior to de-registration with the U.S. Securities & Exchange Commission, Whitehall acknowledged that it had problems, including unprecedented turnover of top management, store closing issues, and financing challenges.

 

Among management’s list of the 28 (twenty-eight) factors that could affect Whitehall’s survival, here are several that management cited in its legal filings:

 

• Five different chief executive officers in 2005
• Major changes in the company’s bank loan facilities, including a reluctance of the banks to continue to advance money, even though Whitehall had borrowing availability
• Store closings
• Need for an equity infusion
• Large operating losses
• A “going concern” opinion by its auditors, who have resigned
• External factors such as the U.S. economy, mall traffic, and others
• Litigation related to store closings
• New developments related to earlier litigation, including shareholder lawsuits

Background of the Merger – Challenges Slammed Whitehall Beginning in 2003

Whitehall’s SEC filings provide insight into the intrigue of a troubled company and how it attempted to extricate itself.

 

Management’s problems began in August 2003 when it was named as one of 14 defendants in a lawsuit brought by Capital Factors. Simultaneously, the New York Attorney’s office began a criminal investigation related to the Capital Factors allegations. As a result of an internal investigation related to the lawsuit and criminal allegations, Whitehall’s chief financial officer was placed on leave in November. In December, both he and the vice president of merchandise were fired.

 

In December 2003, the company also announced that it would restate its financial results beginning with 2000 and forward. By early 2004, plaintiffs’ lawyers were banging at Whitehall’s doors. Shareholder class action suits were being filed almost daily, it seemed.

 

This marked the beginning of the end, in our opinion. Management’s attention to the core jewelry business was diverted by the strain of the challenges facing the company.

 

Momentum carried Whitehall for a while. In the all-important November-December holiday selling season of 2003, same-store sales rose 6.4 percent. They would never see that level again. In the first quarter of 2004, ended April, same-store sales rose by a more modest 3.3 percent. By the second quarter of 2004, same-store sales dropped into negative territory, where they have remained ever since.

 

Throughout 2004, the company wrestled with its legal challenges, and it reached a non-prosecution agreement with the U.S. Attorney in the fall of 2004. It also agreed to pay nearly $13 million to parties related to the Capital Factors litigation. This was precious cash that Whitehall needed to purchase goods for the all-important holiday selling season.

 

Because management’s focus was diverted for most of 2004, its fourth quarter (November, December 2004 and January 2005) same-store sales declined by a dramatic 8.7 percent. Further, the company posted a large loss for the year.

 

In January 2005, the company was approached by the chief executive of another jewelry retailer about the possibility of selling the company.

 

In January and February 2005, the company worked with two different investment bankers to try to develop a strategy that would save the company. Over the next several months, the company talked with several potential buyers.

 

In March 2005, Hugh Patinkin, chairman and CEO, died unexpectedly. All of the parties who had originally expressed an interest in Whitehall decided to forego making an offer for the company.

 

After the death of Patinkin, another industry participant expressed an interest in a business combination with Whitehall. In April, the company received a verbal, informal indication of interest at a price near the then-market price of Whitehall shares of about $7. The board concluded that this offer was inadequate.

 

For most of 2005, the company searched for new top officers, new financing, and resolution of other issues confronting the company. In the midst of these challenges, a rift developed among the board of directors relating to a newly elected board member who had previously sought representation on the board. This added to the company’s woes.

 

By late 2005, bidding for the company was down to two interested parties who would provide financing, if they were allowed to buy the company. Whitehall’s board added to the confusion by backing one investor, then changing its mind to back the other investor.

 

In the end, a group including Prentice Capital and Holtzman Opportunity Fund acquired the company earlier this month.

 

Shareholders’ Equity Nearly Disappeared

As of the fiscal year ended January 2003, Whitehall had $117.9 million of shareholders’ equity on its balance sheet. Its book value per share was about $8.11.

 

As of the fiscal year ended January 2005, shareholders’ equity had declined somewhat to $96.6 million. Over the following twelve months, Whitehall’s shareholders’ equity was decimated: it ended its most recent fiscal year (FYE 1/06) with only $16.7 million of equity, or about $1.18 per share. The graph below shows how Whitehall’s equity declined over the past four years.

 

Source: Company Reports

While it is not unusual for a company to take significant write-offs when it is being sold (many companies use this as an opportunity to clean up their books), the size of Whitehall’s write-down is startling.

 

If we assume that even half of the write-down is not related to the acquisition, then it seems reasonable to question whether Whitehall’s shareholders’ equity as shown on prior years’ balance sheets was correct. It would appear that perhaps Whitehall’s management should have taken write-downs before now.

 

In short, the company may have been trying to prop up its financial perceptions both with Wall Street and with its bankers by delaying asset write-downs and write-offs that should have properly be taken much earlier.

 

Projections Indicate Only Modest Growth

As part of its disclosure for a Fairness Opinion, Whitehall provided financial projections through 2010, which are presented below.

 

Because of the lack of detail, we cannot make a full analysis of the likelihood that the company will achieve these goals. However, we have revised the company’s projections to reflect the closing of 70 units (management originally announced that 77 units would be closed, but this appears to have been reduced to 70 stores). Our new projections are shown on the right hand side of the table.

Source: SEC Documents

 We believe that Whitehall’s assumptions regarding sales per store and same-store sales gains are too aggressive, especially since the company has smaller-than-average stores (about 881 square feet versus the industry average of about 1,200 for chain jewelers). Further, we believe that management’s assumptions regarding its gross margin are also too optimistic. While Whitehall’s gross margin is well below the industry average at current levels, it is unlikely that management can precipitate a recovery as rapidly as shown. With a smaller revised store base (as a result of store closings), the company’s margins could be under increased pressure. That would likely yield a reduced EBIDA and lower cash flow projections.

What Is Next?

Whitehall filed its de-registration papers with the Securities & Exchange Commission in early June. Since the company no longer has any public debt or equity outstanding, financials will no longer be available to the public.

 

Whitehall is suffering from the same malaise that affects all retail jewelers – the continuing need for more and more working capital as a result of a very low inventory turn. Even with the use of “memo” goods (consignment merchandise), Whitehall will still need substantial working capital. Whitehall no longer uses gold leasing as a financing method.

 

Vendors who sell to Whitehall will want to keep a “short leash” on the company. The company could generate cash internally by reducing its inventory levels. However, its inventory mix appears to be out of balance as the result of several recent failed re-merchandising programs. The company could generate cash by closing more stores. However, it appears that it will close fewer stores than it originally planned.

 

Desperate times call for desperate acts. We’d rather see Whitehall announce that it will close a third of its stores or some other dramatic tactic to generate cash, rather than just try to keep doing the same old thing that led the company plunging toward bankruptcy in the first place.