Fashion retailer French Connection (LON:FCCN) shares took a 30% beating in early trade today as there was a double whammy of bad news: firstly that the long-winded sales process had failed to find a purchaser, and secondly that profits would be below expectations this year.
This is a bad hit for many short-term holders, who no doubt were holding the shares in anticipation that several parties would be bidding, forcing the price up (I have made this mistake before). In the longer-term, French Connection has stagnated for some time and sales have actually gone into reverse as the company has scaled down its operations.
Like most things in fashion, brand names are difficult to maintain at the top end of the market as new competition arrives all the time, and so it has proven in this case. It’s catchy ‘FCUK’ logo was in vogue at one stage. In 2004 the company shares were trading at over 450p, but in truth have struggled for some time.
What’s gone wrong at French Connection?
The first bit of bad news was that the strategic review ended without finding a buyer. The aspects now to be concentrated on are:
· further right sizing of the store portfolio while renegotiating the cost base of the ongoing stores;
· close collaboration with the key wholesale customers to continue growing the business particularly in the US;
· increased investment in the online platform to enhance the customer experience and improve conversion, coupled with additional spend on marketing to drive traffic;
· development of the range of license arrangements to seek to increase the product categories available while expanding the current businesses; and
· pursuit of other areas of potential cost savings.
This should have been ongoing already really. The failure of the sales process was in my view a lack of any company wanting to offer much of a premium over the current market cap.
We also have a profit warning at the bottom:
The Company will announce its preliminary results for the year ending 31 January 2020 on 10 March. Reflecting the continued challenging trading conditions on the UK High Street, the Board currently expects the result to be a loss before taxation of between £1m and £2m. UK trading in both the Retail and Wholesale businesses has been more difficult during the second half of the year, especially during the fourth quarter.
French Connection: A tale of two halves
Many aspects around French Connection are not difficult to understand. Here we have a distinctive British brand created by its owner (Stephen Marks) that enjoyed much popularity and success in a previous decade. This next decade, and things have changed somewhat, and competition has intensified fiercely. Primark have rolled out a huge amount of stores and seem to have gained in public acceptance. Chains such as Uniqlo and H&M also funded huge expansion plans worldwide, and there seems to be a branch in every major shopping centre.
In real terms, and possibly nominal ones as well, the average basket of clothes is just as cheap in 2020 as it was in 2000, reflected by the greater amount of competition. This may not have been a problem for the very high-end: firms such as Burberry appear to be doing fine. But for the mid-range it has seen another story. French Connection’s sales make sad reading:
These figures can be explained with a few reasons: retail sales have fallen, shops have been closed and lease values impaired. A resulting recovery has been pinned on the growth of wholesale divisions (selling of clothes to other retailers), and licensing (allowing the trademark on unrelated products such as cosmetics). Wholesale now represents more in terms of sales to French Connection, and is an entirely more profitable way of doing things. This snippet from the annual account shows as such:
It is easy to see why. Stores have expensive rents attached, and many people to employ. Wholesale does not, and as such the license and wholesale segments are balancing out what seems to be a poor one in the retail. Arguably there may be some intangible effects not seen in the figures here as retail stores can be used as one big advertisement which indirectly drives demand for clothes from other retailers (which sales then appear in the other two segments). But undeniably this has been a problem and as the firm say in their update, ‘right sizing’ the portfolio and renegotiating rents needs to happen.
Liquidity may prove to be an issue soon. The net cash position was given as £10.0m in the previous update. Yet future aggregate lease payments are £44.9m – money the company is contractually obligated to pay. If the business is not trading with profits, in the absence of any other funding cash decreases.
A good chunk of the commitment (£12.7m) is due within a year, and another £24.9m due within 2 to 5 years. On poor trading the rate of cash burn is quick, even though the company raised £11.7m from a sale of one of its fashion brands, and the current cash position may give a breathing space of 2-3 years. Alternatively, if trade picks up and the expensive leases drop off, the company may emerge from the other side free from the shackles.
So for now, the liquidity position appears fine: there are many more assets than liabilities. Having negligible intangibles on the balance sheet, the tangible asset position is positive and in line with the market cap. Most of its assets however are in receivables and inventories, and as we have seen at Ted Baker those values may not be what they seem.
Are French Connection shares good value?
A lot depends on how you see the future. At present, the shares attribute very little to the business going forward and simply value it at the net value of all its assets and liabilities.
There should be plenty of opportunity for FCCN in the short-term once the expensive leases are ditched. Its brand name is still reasonably fashionable and can be applied across a wide range of products. It could even be that new stores may begin to open at even cheaper rates than before as the retail climate has created plenty of empty spaces where shops used to be. As we saw in the table above, if the retail performance could improve there is a decent business underneath.
The bear case is whether the brand name can remain relevant and fashionable under a regime where there is very little resources to build an identity. In order to boost revenues, much of the wholesaling activity has been downmarket and to cheaper discounters and it is possible to pick up French Connection clothes very cheaply. This provides an immediate cash boost but at an intangible hit to reputations. I do believe that it is very difficult to reverse once this happens and the brand will be stuck. At some point it there may be very little premium attached to the brand.
Given the level it trades at, it is not expensive at the moment, but I view this as a rather binary situation in that in a few years this could be much higher or lower, but not at the levels we are today. Given momentum is against it at present I would be prepared to wait for a better price. 3/5.