Walks like a net-net, talks like a net-net, but it isn’t one

Leases are not only key to interpreting French Connection’s financial position, they affect valuation.

According to the definition French Connection is a net-net, the ultimate bargain, because the balance sheet value of its current assets, those most easily convertible into cash, minus all liabilities is a fraction of the share price. This was Benjamin Graham’s rough proxy for liquidation value. Quite possibly the company could stop trading, sell its assets, repay its liabilities, and still have more than enough money left over to justify investing in the company at the current price.

But that might not be true of a company, like a retailer, with large lease obligations, rent it’s committed to paying for stores. I’m not sure if Graham had to grapple with leases. Their pervasiveness may be a modern development, as companies realise they can exploit the fact that lease obligations, unlike debt, are not recorded on the balance sheet. 

Operating leases are, in the main, long-term obligations, so if we add their value to the balance sheet they become long-term assets, like property plant and equipment, and liabilities, like long-term debt. Since the net-net calculation deducts liabilities from current assets only, the assets don’t count but the liabilities do.

Including leases at face value gives a net current asset value of minus ''160m. In other words liabilities exceed current assets by ''160m, so there is no net current asset value (minus ''79m).

Using Graham’s slightly more refined liquidation value measure, which reduces the value of non-cash current assets to reflect the fact that stock is likely to be sold off cheaply if the company is going out of business but includes heavily discounted values of long-term assets, like the leases, also gives a negative result (minus ''79m).

The shares are very cheap. The market value is 38% below the value of tangible book value, but French Connection is not in ultimate bargain territory.