Gareth sent me through a preliminary review of UK retailer French Connection this morning. Some excellent analytical insights, and a few cheap Friday laughs to get you through the day…
II Funds – Opportunity Review 18/4/13 – French Connection Group (£0.28)
5 key ratios
French Connection Group
1. Net current assets per share
2. NTA per share
4. FY13 EPS
1. Company description
French Connection Group is a branded fashion company selling mainly clothes but also toiletries, eyewear, watches, fragrances and jewellery, often under licence agreements. The brand ‘French Connection’ makes up 88% of revenues, with the remainder attributed to Toast, Great Plains and YMC (it offloaded another brand relatively recently).
In UK/Europe and North America (two separate reporting divisions) it offers product through branded retail stores, e-commerce and concessions in department stores. It also supplies wholesale customers including department stores, multi-brand stores and franchises in parts of Europe. The third division, Rest of World, includes branded franchise operations and wholesale sales in Australia, most of Asia including India and South Africa. In Hong Kong and China, though, it’s a retail operation (branded stores and concessions) run through a 50:50 joint venture.
Sales peaked in 2003/2004 when the marginal fashionista bought themselves a fcuk-ing cliché of a t-shirt, and sales have been on an uninterrupted slide since—but by less than I would have guessed, from £268m in the year ended 31 Jan 04 to £197m in the year ended 31 Jan 13 [SJ note: £ weakness would disguise a much larger fall in underlying volumes].
2. The opportunity and key value drivers
The chief attraction is the group’s pile of cash, £28.5m at 31 Jan 13, which trumps the market capitalisation of £27m to create a negative enterprise value (no debt). It isn’t a ‘net cash’ play, with total liabilities of £44m (overwhelmingly trade and other payables) larger than cash, but it is a net-net depending on what discounts you might apply to inventories etc. Straight off the balance sheet, total current assets of £93.8m – including £28.5m cash, £23.7m receivables and £41.5m inventories – less £43.8m of total liabilities leaves £50m of net current assets, with the current market cap offering a discount of 46%. On a first-glance basis, price-wise it belongs in our Japanese net-net portfolio.
Unlike the Japanese portfolio, though, French Connection is not currently profitable, not paying a dividend and the cash/asset pile has been eroding (plus subject to seasonality, discussed below):
Balance Sheet as of:
of which is cash
Net current assets
The chief problem has been that the retail operations in UK/Europe, whose operating contribution in the year just passed was -£16.0m, including net -£1.1m for store closures, on a 10% sales fall to £103m. Retail operations in North America fared little better comparatively, a 10% sales fall to £20m leading to a contribution of -£1.6m.
Thinking things through using Charlie Munger’s cancer surgery model (cut away the sick bits and see if anything useful remains) provides some hope. While wholesale sales in Europe fell 19% to £34.2m, it still made an operating contribution of £3.9m (down 41%). And North America wholesale saw a 19% increase in sales to £29.0m and $7.8m operating contribution, up 37%. Rest of World, which is all classed as wholesale, sales fell 32% to £10.7m, mainly because of ‘reductions in deliveries to our licensee in Australia in a difficult retail market’, leading to an operating contribution of £0.5m, down a fraction. There was also £6.5m of contributions from net royalty income from brand licencing, down 24% mainly due to the termination of the Sears licence agreement a year earlier. Adjusting for an intragroup matter and deducting all current overhead costs (conservative), the cancer surgery model (ignoring UK/Europe and North America retail) leads to overall contribution of £13.8m, or £8.5m after deducting group management overheads (again, conservative). It could be cheap using this approach.
But that neglects two things. Perhaps least importantly, the demise of the retail network of a clothing brand doesn’t tend to bode well for future wholesale sales—one decade you have crowded stores in New York and Oxford Street, the next you’re fretting over losing the Sears contract.
More pressingly, the retail operations have been bleeding cash for a few years. From what I can tell without walking into one, they still have a high price strategy—average garment price tag of around £100—and perhaps there’s a lever to pull there somehow, but it’s a desperation lever for a fashion brand. The brand and many of its stores have lost relevance.
The company is cagey on numbers, but according to an article in the Guardian, FC has been trying to offload 15 of its underperforming stores in the UK (out of a total of about 74 stores across UK/Europe, excluding clearance and concession), and I wouldn’t be surprise if the final number of bad stores is higher. Again, relying on that article, during the last year they managed to close three and it cost them £1.1m in provisions, and presumably they were the lower hanging fruit. Unscientifically extrapolating, one might expect a £5-10m cost to close the already identified underperformers, and none of this is a liability on the balance sheet. And still then there will be 60 stores that aren’t exactly gushing cash. Net cash after a workout, if it came to that, is likely to be significantly lower and likely evaporate entirely.
Importantly, it’s worth noting that at the full year balance date, the company is pregnant with Christmas cash. At the 31 July 2012 balance date, it was £21.2m and I suspect that’s also inflated somewhat by late summer clearance. I haven’t seen an average cash balance anywhere, but the company was transparent enough to disclose that the minimum cash balance over the past year was £10m. That was likely to coincide with higher inventory and receivable balances (likely just prior to Christmas period), but it does jeopardize the net-net theory even without considering future outflows.
3. A summary of risks
I think it’s incorrect to treat this as a net-net. A portfolio of 30 profitable, dividend paying net-net Japanese equities and I’m confident we’ll make money. If we bought 30 French Connection equivalents instead, I’d be far less certain, we’d be completely reliant on a handful of them engineering big turnarounds.
First the net asset status is uncertain, due to seasonal timing and the unrecorded liability in terms of working out of underperforming retail stores. Then there’s the negative profit/cash flow caused by the disappointing retail operations and the questionable relevance of the brand (really, the success of fcuk campaign almost assured the eventual irrelevance of the whole brand – it was the Hypercolor of the late 90s, early 00s).
This should be viewed instead as a turnaround play. And on that regards, I don’t have any confidence.
Would appreciate any differing views from the team but otherwise I’m leaving this one alone.