French Connection (FCCN)

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.

9 Replies to “French Connection (FCCN)”

  1. Richard Beddard

    I must take a closer look at the lease situation, but I’m presuming they’re long-term leases and the cost of getting out of them is more than running stores that are currently loss-making. It would be a big relief, frankly, if French Connection said it was going to close down some of its unprofitable stores.

    Reading Next’s reports is absolutely fascinating. It’s so much more profitable, and geared up to its eyebrows. The company seems to have no fear buying back hundreds of millions of pounds worth of shares every year rather than reducing debt.

    I keep asking myself what’s the difference? Maybe it comes down to product. French Connection is more up-market, more edgy, and more expensive. Perhaps the ‘squeezed middle’ are all going to Next instead.

    • John Kingham

      I don’t see that Next is heavily geared. Using debt to equity it is, but it only has about £6-700M in bonds, which is just over a years profit. That’s nothing. Interest cover is 25 times, so interest payments are just a few percent.

      The debt to equity is skewed because they have an odd balance sheet partly because they don’t have much cash.

      French connection have almost as much cash as current libilities, debtors or inventory. If Next were they same they’d have perhaps $4-500M in cash, which of course they don’t, it’s more like £50M. I guess that cash has gone out the door on share buybacks which make shareholders richer (assuming the price goes up with the buyback) without them having to pay income tax.

      • Richard Beddard

        Well, I have to admit I’m flummoxed by it. I can see that they can easily afford the interest, and that its been exceptionally profitable for a long time so investors and management must get a lot of confidence from that. I just don’t think its wise to spend every spare penny on buybacks when retailers face so many headwinds now.

        If they suspended the buyback for two or three years they could repay most of the debt! The management are obviously very confident in the business but I wonder if they’re stuck with the policy as the expectation is they will juice eps for all its worth. Some caution, surely, would be a good thing. People didn’t think M&S could stumble, but it did.

        • Richard Beddard

          As as happened before I find myself drafting my next blog on EV’s site! The thing that disconcerts me about Next is its financed mostly by debt, suppliers, and landlords, all of whom can withdraw financing if they company’s fortunes change (admittedly something that is inconceivable to most investors for a company like Next). Because of the buybacks, equity, what’s left after you deduct debt and other payables is just 6% of total assets, which as you say looks pretty tortured. The interest cover figure is flattered though because it ignores rent. If we treat leases as a kind of debt and rent as a kind of interest by adding lease payments back to operating profit and adding them to interest bill and then dividing the latter into the form we get ‘interest and rent’ cover of 3.3X. That’s better than the 2X I calculated for JD Sports: http://blog.iii.co.uk/fashionable-jd-not-for-me/ but still a lot less than 25X!

          Unfortunately I can’t calculate interest plus rent cover for French Connection as I can find interest payments in its annual report.

          I don’t know how risky Next is, but I reckon it’s riskier than market and management think, lulled into a false sense of security by its long and consistent run of profitability.

          That’s my working hypothesis!

          • Lewis

            Nice little discussion here!

            As it happens, I’d tend to lean towards Richard’s opinion, but probably not so strongly. I can certainly see why it’s beneficial for companies to have a capital structure like the one Next is running, and from a classical economic perspective I love that ‘efficiency’ argument in the use of capital.

            A little part of me wonders if I would’ve said the same thing about any number of heavily indebted companies, though, and I suspect the speed at which things could flip is rather dangerously accelerated when there’s that level of debt.

            Hm. As with FC, though, if they’re doing well now they should do ever better in the future – so perhaps I’m overplaying the downside. Either way, I still prefer N Brown to both. I like their niche appeal, easier space for expansion, and a complete disassociation from the high street which gives me so much pain!

  2. Mark Carter

    FCCN seems to have two distinct phases: the early part of the last decade, when it had double-digit operating margins, and the later part, where they were either wafer-thin, or negative. There’s clearly some risk in this one, as it’s a bit of a gamble as to whether they can regain their margins. Their one saving grace is that they’ve got oodles of cash.

    Quite a tricky one, this fellow, I can see it going either way.

    • John Kingham

      I would be slightly miffed as a shareholder at the amount of cash they hold. A sensible counter-cyclical buffer is a good idea but I think they have far too much. I would rather they gave my cash back to me so that I could do something useful with it rather than it sit in their bank account earning 1%.

      • Lewis

        Quite.

        That’s always an interesting dichotomy – companies that look ‘safe’ probably look safe because, for shareholders in the last 10 years at least, their capital wasn’t particularly well used. Cash on a balance sheet is nice to see, but only in the sense that it can be returned to us. Large amounts of cash permanantly sitting on the balance sheet makes me think I could probably get a better interest rate myself, if I wanted to – I don’t need an intermediary for that!

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