In for the long haul

Impressed by Next, I’m reappraising French Connection. Perhaps management could have done more to stave off losses at its stores and the latest profit warning contains disturbing news about cash flow.

It's a clich'' but FCUK was an iconic fashion brand. French Connection fashions are sold wholesale internationally and through the company’s own stores and department store concessions in the UK, primarily, the US, and recession-bound Ireland, Spain and Portugal. The company also has two stores operated as joint ventures, one in Honk Kong, and one in China, and smaller brands YMC, TOAST and Great Plains. It receives income from ranges of spectacles, toiletries, watches, fragrances and jewellery which use the FCUK and French Connection brands under license.

Bargain / Recovery / Cyclical / Stalwart / Growth

While wholesale, licensing, and international operations are growing at varying speeds and overall it made a modest profit last year, French Connection is losing money retailing in the UK, Europe and North America, which accounts for 60% of sales. Costs like rent are fairly fixed or, like cotton prices, volatile, but revenues are falling as customers restrict shopping to sales periods, or find bargains on the Internet. Since French Connection targets the high-end of the middle-market, it’s vulnerable to cheaper brands during slow-downs.

Expectations

To keep prices and sales up, French Connection has launched an exclusive premium range for women, a range of homewares, and aims to minimise discounting. To keep costs down it’s negotiating lower rents as leases expire, six this year and eight next out of 71 stores in total, and will close unviable stores. Press reports suggest the company may go further, and sell off some of its most expensive leases before they expire but turning the stores around will take "a number of seasons", which could mean years, and if they require refurbishment it will add cost.

Threats

competitive position ' weak
Though French Connection’s vulnerability to cheaper brands is cyclical, the down-cycle this time is prolonged. The fading of the FCUK brand and the emergence of the Internet are more intractable dents in its competitive position.

finances ' neutral
I’m reluctant to say French Connection’s finances are strong, despite the fact it has no debt or defined benefit pension scheme. The retail stores are losing money partly because of lease obligations agreed when they were profitable. Those obligations are a kind of debt not recorded on the balance sheet. Include them at face value, and French Connection’s tangible assets are almost 80% funded by ‘debt’.

Falling retail revenues reduced the cash balance from ''18.5m at the end of April 2011 to ''11.3m at the end of April this year. A falling cash balance is a bad sign because cash pays the rent and it’s clear too that the end of year cash balance, which in recent years has typically been over ''30m, is flattered by sales over the Christmas period. At other times of year the company’s finances are weaker.

management ' neutral
Founder and executive chairman Stephen Marks has the experience and the incentive (a large shareholding) to turn the company, his life’s work, around but he was slow to act as the profitability of the UK stores declined. I wonder if he gambled on a short recession and four years in he’s facing a protracted one.

valuation ' cheap
The shares trade at a 60% discount to tangible book value.

-

Verdict

The shares are very cheap, but the stores aren’t profitable in recession or near recession and if French Connection can’t turn them around until the economy recovers, they could put the whole company in jeopardy.

Its eroding cash reserve and profitable wholesale, international and licensing operations give French Connection some time but I feel nervous enough about the Thrifty 30′s holding to have considered ejecting the share from the portfolio.

I haven’t, because turnarounds are rarely smooth and it’s foolish to buy shares in a company you expect to turn around, only to be shaken out by a temporary reversal.

However, the protracted recession and what looks like accelerating losses in the retail portfolio mean I’m not as confident as I’d like to be the latest set-backs are temporary.

Notes

• Profit warning, April 2012
• Next v French Connection
• French Connection, TOAST, YMC, Great Plains
• Performance in year to 31 Jan 2012
• Effect of leases on financial strength and valuation
• Stephen Marks: holding ratio
• More about French Connection
• Blogger Expecting Value charts French Connection’s falling popularity (via Google)
• Poppy Dinsey on French Connection
• The Thrifty 30