On loosing faith

Thursday's trading update upended French Connection's recovery credentials. The problem is its shops and department store concessions in the UK and Europe. There were 128 of them in January, and they're not profitable, although that much we already knew.

The company provides a convenient breakdown of revenues and operating profits in the main body of its annual report:

Of all its divisions, retail in UK and Europe (rather ominously consisting of stores in Ireland and concessions in Portugal and Spain) has the highest gross profit margins, but deduct costs and it made an operating loss in the year ending January 2011.

By contrast, at the wholesale divisions supplying franchises, retailers and online shopping sites like ASOS, gross margins are lower because the retailers takes their cut, but at least French Connection makes a profit, because its operating costs, like staff and rent, are much lower.

Having closed all of its stores in Japan, and many of its stores in the US, French Connection is successfully growing at home and abroad through these wholesale channels which include 199 branded licensed or franchised outlets in Australia (80), India (25), China (20), the Middle East (13).

Judging by the 9.5% collapse in third quarter like for like sales at its own stores closer to home, things are getting worse. Where the company sees 'significant opportunity for improvement', the market, the shares fell sharply on Thursday, probably sees a money pit that could swallow the profit from the wholesale divisions.

Barring the perpetual effort to design attractive clothes and market them as cost effectively as possible, recovery in the High Street depends on an improvement in consumer confidence, which in turn depends on the state of the overall economy, and on refining French Connection's portfolio of stores, a euphemism (of mine) for closing down unprofitable ones.

But French Connection is not closing stores. Most are on long-term leases with upward-only rent reviews, which explains the high costs.

About six leases come up for renewal every year and last year only one store was closed in the UK and Ireland, which leaves French Connection relying on the strength of its balance sheet and the profits from the wholesale divisions to bankroll its retail operations until the economy improves or it somehow ups its game.

Ignoring operating leases, which company accounting largely does, French Connection has a strong balance sheet; ''31m in net cash at the half year in July and nearly 60% of assets funded by shareholders' equity. If we add in the amount owed to landlords, though, that ratio drops to 24%.

It may sound like I've lost faith in French Connection. I haven't really. With the price down at 60p, the story is much the same as it was when I added the company to the Thrifty 30 at 43p a share in April last year. Then I took the opportunity to add an iconic brand run by an experienced chief executive with a 40% stake in the company on the cheap, thinking it might take years to recover.

But events unfolded more quickly. The company surprised the market in February this year by reporting a strong recovery in its full year results and the shares rose to a high of 134p. Had I been on-the ball then, I may have 'sold' with the price approaching 2 times book value, but I didn't review the company when it published its annual report as I should have done because I was concentrating on finding new companies for the portfolio.

In other words I let my value discipline drop, and, as always happens on these occasions, I've lost a little faith in myself.