Rags to Riches
A modicum of grace rarely seen in my titles sees me shunning the obvious FCUK (French Connection UK , for my readers overseas!) related punnery for a slightly more restrained, though equally terrible tagline. I never promised to be original! For those of you who don’t know the brand, French Connection are a £50m market cap retailer, operating stores and wholesaling clothes to other shops. They’ve seen their share price drop from a peak of 134p in March to 51p now on continued worries about the wider macro environment and UK consumer spending – all the stuff you would expect, really – and that leaves them looking rather cheap on a forward and historic earnings basis. As an aside, it’s also a share that Richard Beddard holds in his Thrifty 30 portfolio; the price decline being bad news for him but throwing it into my face for analysis.
Running down the stats on the right, then, and you get rather mixed messages. The graph isn’t particularly pretty – if, like me, you think a pretty graph has 3 roughly parallel lines moving upwards steadily – though the balance sheet is very strong for a retailer, and earnings have recovered well from the big losses in 09/10. As I often say, any retailer doing well in this environment finds itself in a very positive light in my eyes; my view being that if they can eke out even a small profit in the sort of conditions we’re currently seeing, I have faith in them to perform when things invariably do pick up, whenever that may be. Regardless of stage in the cycle, though, the graph tells us that margins are very slim indeed (operating at ~3.5% last year, slightly better pre-crisis). That’s the retail highstreet, I suppose.
What I really want to know is whether French Connection can go back to earning what they did in 2006; that’s the sort of profit level that’ll see me earning a strong return on my investment, if maintained. Last year may look close from eyeballing the graph, but in reality it uses the more flattering pre-exceptional figures, which eliminate the cost of disposing of a few underperforming businesses. As always I use pre-exceptionals as they probably represent a better basis on which to look forward, but it should be noted that the shifting retail landscape is still having an impact on their figures.
My initial feeling on the business is one of ambivalence and uncertainty; rather unexpected given the size of the price decline. I had expected to be lured in by the headline cheapness and have to moderate my opinion with caution on the macro outlook, but I’m not as taken as I thought I would be with the whole story. The real strong point, obviously, is the great balance sheet so rarely seen on a retailer; but I’m not sure I even care that much about the balance sheet in this case. Its value pales in comparison to the future value of potential cash flows, and the operating lease commitment erodes some of the margin of safety there anyway. They tower over the balance sheet and ensure in any sort of prolonged loss scenario there’s a huge degree of uncertainty. The impact of the lack of debt and liabilities is simply to ensure that all the shareholder returns go to the shareholder, then, and so in a bizarrely cyclical twist of reasoning I conclude that even the strong balance sheet doesn’t present me with much of a margin of safety, and as such I should consider their future potential earnings with renewed vigour.
The forward and historic P/Es are both very cheap, though, so what gives for me? Normally those are the type of figures I love to see, but unfortunately the problem is exactly the scenario which gave rise to the opportunity in the first place – a trading statement last week. It highlights growing divergence between performance in different business sectors and geographies, with the largest classification – UK/EU retail – revenues down a rather significant 9.5% YoY for the quarter. As this accounts for over half of the group’s total revenue, any hits in this sector are particularly damaging for the overall performance. Strong figures continue to come out of the wholesale businesses, which continues to be far more profitable than the retail side, and leaves me questioning why the retail side still needs to play such a significant role in the operation of the business as a whole. It seems perfectly reasonable to start trimming down that store estate, but that doesn’t seem to be happening; perhaps there is an element of retail stores giving the brand the ‘prestige’ to make strong margins on wholesale.
The mix of situations is painful, as it’s obvious there’s still a good business underneath; but a 10% drop-off in retail sales would have genuinely surprised me. I understand the consumer is hit, but he wasn’t feeling too fantastic last year, either. In the end, I can’t help but comparing to two businesses with striking similarities – N Brown and Mothercare. N Brown is similar to French Connection in as much as they sell clothes, but distinct in that they follow mainly online/catalogue distribution methods and therefore have far less of the fixed cost issues French Connection do. Both, though, are rated rather poorly by the market (N Brown on a P/E of under 10) and both trade in a sector I like. I think people will still buy nice clothes, they’re just deferring spending until things are a little more certain. Mothercare strikes me as similar story in the divergence of the two different parts – the international operations and the UK. There I noted that the international business alone was fantastic and extremely profitable, but was dragged down by a terrible UK store performance. I just wonder whether I am doing exactly what I try to avoid – perpetuating current retail difficulties endlessly – and am missing the potential in two companies who, if they return to historical levels of profitability, will be very good places for my money indeed.