Thursday, September 29, 2005

Whitehall Jewellers

Now that Finlay is out of the way, I thought I'd take a look at one of its comparables called Whitehall Jewellers. Over the past couple of weeks, this stock has tanked from a high of 6 to 1.38 today--and I got to wondering, what the heck made this happen?

There has been nothing but bad news for this company over the past year, and starting September 8th, everything went down down down. Prior to the huge drop, Whitehall Jewellers has had a two-year history of corporate fraud and lawsuits regarding the transfer of money by the CFO. They paid approximately $20 million in legal and professional fees which pretty much killed their cash balances. And when the original executives left office, they put in place a new CEO nammed Raff. A little bit before September 8th, Whitehall Jewellers had asked the AMEX to suspend trading on their stock prior to the announcement of what they considered to be "significant news". Lo and behold, after a couple of days of investor suspense, a press release comes out stating the resignation of the newly appointed CEO who hasn't even started her term. This sent the stock tanking from around 4 to 1. And now, default notices from creditors are coming in as Whitehall straps itself for a rough ride. It has no cash reserves and looks to be on the brink of bankruptcy.

Why is this opportunity interesting? Just today, the stock went from 1 to 1.38 a share--and at first glance this may seem just like market madness. But could it be that the markets overreacted to all this news?

Looking at the balance sheet, one will notice a book value of approximately $80m on Yahoo! Finance... and the stock's total market cap is currently 19.88m. Whoa whoa. You can buy this company for 20 cents on the dollar? At least, when you think Jewelry store, you automatically think inventories filled with gold, riches and diamonds... Of course the markets have overreacted! How could they not have seen that even if the company did go bankrupt, it would still liquidate at a higher value than what investors are willing to pay for? Perhaps that the big realization of today...

Taking a much closer look at the balance sheets, one will notice that it's tangible book value actually derives from some things which aren't so "tangible" after all. There are 3m in deferred tax and deferred costs, and some other things that decreased the value of tangible equity. The biggest whammy was perhaps the 52m worth of "Property and Equipment". Property and equipment sounds misleading here, because the only "property" this company has is furniture and fixtures, and some leasehold improvements they probably won't be able to sell off unless it's at a significant discount, along with capitalized operating lease expense. Ha. Equipment is more like software development costs they've capitalized... in other words, property and equipment could probably only be realized at most 5 - 10% of its balance sheet value on liquidation.

This still puts us at a 26m real tangible book value however, and the market is currently pricing the company at 18.99m. Buy! You say... that's still a hefty upside! Ahh... that is where you must reconsider my investor friend--you see, this company is far from complete in paying off its legal expenses and recruiting expenses for a new executive going forward. It will probably end up losing money again if they don't go bankrupt. In fact, it's conservative to estimate that they will lose 10m again this year. So pricing in that expectation, in a year, the book will be worth 16m.

2m downside v. a 8m upside is a great bet, you say? Well, let me go a step further that default on credit doesn't necessarily mean "liquidation" (chapter 7). It could also mean "reorganization & restructuring" (chapter 11), which would put the debtors in charge of the company going forward--all debt converts into equity, with liabilities forgiven. Now, you might think it's still the same 26m left to equity shareholders going forward even with that happening, because now you have the decreased debt to make up for the dilution in equity. But ahh, think back again to the 10m they will be expected to lose on legal expenses for a longer time to come, or more generally, think of future losses this company will suffer without a proper management and cost structure. If that continues year on year, eventually, the original equity will be pushed near zero, and that, my friends, is the major downside risk.

No buy! (but will buy at $1.00 per share). That's our thesis and we're sticking to it :D

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