Why I Believe French Connection Can Triple My Money

08 January 2015
By Maynard Paton

Today I am going to explain why I believe the shares of French Connection (FCCN) can one day triple my money.

Before you become too excited, let me say that my average buy price here is 31p — as compared to the recent market price of 55p.

Nonetheless, I believe there is still good upside to be had and I reckon the shares could trade above 100p if all goes to plan during the next few years.

However, this £53m fashion chain is by no means a one-way bet.

In particular, the group’s track record is extremely haphazard and I would not rule out further setbacks occurring. A quality buy-and-forget investment it is not.

Drawing me in originally were:

• Simple accounts boasting a cash-flush balance sheet;

• A long-time founder/owner who appeared committed to the business;

• A possible turnaround that could occur independently of wider economic events;

• A profitable wholesale division and notable licensing income;

• The possibility of significant share-price upside if respectable profits could once again be generated on sales that remained close to £200m.

Just so you know, I first bought during July 2011 and last bought during November 2012. I have paid as high as 69p and as low as 21p. I sold 28% of my holding during March 2014 at 62p.

I attended French Connection’s AGM last year and here is a copy of the short report I wrote at the time.

At A Glance

• Small-cap fashion chain with 400 operated/franchised stores worldwide

• Poor sales, reduced gross margins and high cost base have created losses for the last few years

• Cash pile, veteran chief, fresh staff and improved results support turnaround hope

• Upside could be considerable if profits can return to respectable levels

The lost decade after FCUK

French Connection (FCCN) was established during 1972 and today operates 128 clothing shops and concessions in the UK, as well as 14 stores in the States.

The company also sells its clothes wholesale to more than 250 franchised shops — and numerous other stockists — around the world. Further income is earned from third parties paying license fees to produce branded FCCN items such as shoes, bags and toiletries.

I guess FCCN came to most people’s attention during the mid-2000s with its FCUK brand.

Back then, clothes carrying the contentious logo helped the chain’s annual profits reach £30m-plus and push the share price beyond 400p. But the popularity of the infamous brand could not be maintained and the business has generally struggled ever since.

In fact, profits had turned to losses by 2009 and, following a brief recovery, further losses were recorded during 2013 and 2014. The dividend was last seen two years ago and the shares have traded as low as 20p.

Put simply, FCCN’s difficulties have been due to designing unpopular clothes and trying to sell them at premium prices from a costly retail estate.

Yet all may not be lost.

In particular, a “broad range of significant initiatives” was launched during 2012 that targeted a break-even performance for the current financial year (ending January 2015). The restructure has seen stores closed, certain countries abandoned and sub-brands sold.

What’s more, a clutch of new managers — including a new Head of Design, a new Head of Retail and a new Head of Production — were appointed to revive the business and its product range. So far at least, these new recruits appear to be making progress.

Here is the haphazard financial history

The table below summarises FCCN’s recent ups and downs:

Year to 31 January	2010	2011	2012	2013	2014
Sales (£m)	212.5	213.8	215.4	197.3	189.4
Gross profit (£m)	109.1	110.6	103.6	94.6	90.2
Operating expenses (£m)	(116.2)	(112.7)	(109.2)	(108.9)	(101.4)
Other operating income (£m)	4.9	5.8	8.5	6.5	6.1
Finance income (£m)	0.1	0.2	0.9	0.2	0.1
Joint-venture income (£m)	0.4	1.5	0.8	0.4	0.6
Underlying group operating profit (£m)	(1.7)	5.4	4.6	(7.2)	(4.4)
Other items (£m)	(6.5)	3.5	0.4	(3.3)	(1.7)
Profit before tax (£m)	(8.2)	8.9	5.0	(10.5)	(6.1)

Given the recent losses, I’ve been quite happy with FCCN’s progress during the last twelve months.

In particular, Christmas 2013 witnessed better-than-expected retail sales and margins, while Spring 2014 saw like-for-like shop sales surge 11%.

Meanwhile, May’s AGM statement was notable for announcing the decision to skip a mid-season sale. This news suggested the business was enjoying an improved product range that could be sold for longer at full price. September’s interim results confirmed greater full-price sales by showcasing improved gross margins and reduced losses.

Although FCCN blamed the warm weather for like-for-like shop sales dropping 6% during the Autumn, the retailer once again said gross margins had improved (by 250 basis points) and that losses had been “marginally reduced”. Wholesale revenues were reportedly 9% higher, too.

Of course there is still the crucial Christmas 2014 trading update to come, which could completely negate all of these positive developments.

Still, from what I have read of late, it does seem FCCN is slowly clawing its way back to break-even. The gross margin improvements are certainly encouraging.

A rundown of the important numbers

I quite like FCCN’s annual reports. For one thing, the ludicrous fashion photography that riddled old editions has been ditched — and the 2013 and 2014 versions were published in lovely black and white with no pictures! That change alone tells me this business has become a lot more serious about its shareholders.

Within the actual accounts, the balance sheet is the main attraction. It shows no debts, no pension liabilities… and plenty of cash to help support the turnaround. The bank balance fluctuates significantly during the trading year, and has been recorded at between £9m and a mighty £28m (29p per share) during the last twelve months.

Tangible book value was last declared at £51m, or 53p per share, but this valuation measure does not attract me.

You see, FCCN carries substantial lease-payment obligations that are not shown on the main balance sheet, but are real-life liabilities that will have to be paid.

Indeed, FCCN is on the hook for non-cancellable lease payments that total £160m, although I’m pleased that number has reduced substantially during the last few years.

Year to 31 January	2010	2011	2012	2013	2014
Operating leases that expire:
within one year (£m)	(7.3)	(3.4)	(5.8)	(4.1)	(0.9)
within two to five years (£m)	(35.3)	(34.4)	(28.4)	(25.1)	(24.5)
after five years (£m)	(222.9)	(221.6)	(183.0)	(165.1)	(134.9)
TOTAL	(265.5)	(259.4)	(217.2)	(194.3)	(160.3)

On the subject of leases, it’s worth a quick look at FCCN’s annual lease charge.  Past problems have been caused by costly and under-performing premises, so I’m glad the annual lease expense and cost per square foot of space have reduced.

Year to 31 January	2010	2011	2012	2013	2014
P&L lease charge (£m)	(40.1)	(32.6)	(28.1)	(28.4)	(26.6)
Store/concession space (sq ft)	333,308	336,960	333,569	327,675	312,736
Lease cost per sq ft (£)	(12.03)	(9.67)	(8.42)	(8.67)	(8.51)

FCCN’s other major cost is staff. Good progress has been made here, too. With fewer stores, staff numbers and the associated charge have reduced.

Year to 31 January	2010	2011	2012	2013	2014
Staff number	3,173	2,834	2,558	2,444	2,258
Staff cost (£m)	(53.5)	(45.9)	(42.6)	(41.1)	(38.9)
Average staff cost (£)	16,861	16,196	16,654	16,817	17,228

For the record, I can see no problems with FCCN’s cash flow:

Year to 31 January	2010	2011	2012	2013	2014
Underlying group operating profit (£)	(1.7)	5.4	4.6	(7.2)	(4.4)
Depreciation and impairment (£m)	5.5	3.7	2.8	3.1	1.9
Net capital expenditure (£m)	(2.8)	(1.0)	(1.6)	(1.7)	(0.8)
Working-capital movement (£m)	7.3	(1.6)	(4.5)	1.0	5.0

Cash capital expenditure has been adequately covered by the depreciation charge, while working-capital cash movements have generally been positive.

He chaired the AGM wearing a T-shirt and jeans

Anybody holding FCCN shares has to accept their returns will be dependent on founder Stephen Marks.

It was quite clear from my AGM attendance that he runs the show. I guess that’s because he has:

• A 41%/£22m shareholding;

• Been the boss since Day 1;

• Employed the same operations director for 20 years, and;

• Ensured he, his finance director and his operations director outnumber the two non-execs.

The dominance of Mr Marks will not suit everyone, and doubters will argue he has to shoulder the blame for all of FCCN’s setbacks.

But the chairman does offer vast sector experience and I can’t fault his tenure and commitment. Plus he has turned FCCN around before — the business almost went under during the early 1990s.

Mr Marks is now in his late 60s — and I was assured at the AGM he can still pinpoint winning designs. The problem he’s faced in recent years, apparently, has not been having that many good designs to choose from.

Turning to pay, well, let’s just say the board’s wages look quite generous for a loss-making small-cap. Collecting bonuses when profits fell in 2012 and when losses were recorded in 2014 also niggle me.

At least recent years have witnessed minor pay inflation and an almost-unchanged share count due to a minimal option culture.

These sums tell me the shares could top 100p

This next table details the second-half of FCCN’s 2014 financial year (ending 31 January 2014) alongside the latest first-half results:

Six months to	31 January 2014	31 July 2014	Total
RETAIL
Sales (£m)	61.7	49.9	111.6
Gross profit (£m)	35.4	28.7	64.1
Operating expenses (£m)	(38.5)	(36.2)	(74.7)
Operating profit (£m)	(3.1)	(7.5)	(10.6)
WHOLESALE
Sales (£m)	37.8	34.1	71.9
Gross profit (£m)	12.3	11.1	23.4
Operating expenses (£m)	(5.6)	(4.9)	(10.5)
Operating profit (£m)	6.7	6.2	12.9
RETAIL and WHOLESALE profit (£m)	3.6	(1.3)	2.3
Licence income (£m)	3.3	2.9	6.2
Common and group overheads (£m)	(5.5)	(5.6)	(11.1)
Finance income (£m)	0.0	0.1	0.1
Joint-venture Income (£m)	0.3	0.0	0.3
TOTAL OPERATING PROFIT (£m)	1.7	(3.9)	(2.2)

You can see for yourself the retail division is currently losing a hefty £10.6m, while the wholesale division and license income help to shore up the numbers.

My assumptions for what could happen are listed below:

My assumption	Achievable?
Retail sales advance 10% to £123m	£123m was reported in 2013
Wholesale sales advance 10% to £79m	Last update indicated a 9% improvement. £82m was reported in 2012
Retail gross margins advance to 60%	Currently 57.5% and recent statements have indicated 200 basis-point improvements. 60% was regularly reported up to 2011
Wholesale gross margins advance to 35%	Currently 32.5%, with 35% reported between 2011 and 2013
Licence income remains at £6.2m	£6m-plus was reported in 2013 and 2014
All other operating income and costs remain the same	Greater sales could mean greater overheads, but the cost base has been reducing of late

Importantly, I don’t see my assumptions as outlandish. In fact, everything I’m hoping for has already been achieved at some point during the last few years.

Anyway, here’s what those assumptions could produce financially:

	Year to 31 July 2014		My Projection
RETAIL
Sales (£m)	111.6	Increases 10%	122.8
Gross profit (£m)	64.1	Margin improves to 60%	73.7
Operating expenses (£m)	(74.7)	Unchanged	(74.7)
Operating profit (£m)	(10.6)		(1.1)
WHOLESALE
Sales (£m)	71.9	Increases 10%	79.1
Gross profit (£m)	23.4	Margin improves to 35%	27.7
Operating expenses (£m)	(10.5)	Unchanged	(10.5)
Operating profit (£m)	12.9		17.2
RETAIL and WHOLESALE profit (£m)	2.3		16.1
Licence income (£m)	6.2	Unchanged	6.2
Common and group overheads (£m)	(11.1)	Unchanged	(11.1)
Finance income (£m)	0.1	Unchanged	0.1
Joint-venture income (£m)	0.3	Unchanged	0.3
TOTAL OPERATING PROFIT (£m)	(2.2)		11.6

As a reality check, my estimated sales and profits result in an operating margin of 6%, which does not seem outrageous. FCCN has in the past talked of recovering to 10% margins.

Anyway, after applying tax at the standard 20%, earnings could top £9m or 9p per share if my guesswork comes good. Then mix in a middling P/E of 12, and I get a prospective market cap above £100m and a share price above 100p.

That looks good  to me with the shares currently at 55p. Indeed, the potential returns would be quite respectable if my predicted turnaround can be achieved in less than five years.

There is a good chance I could soon look like an idiot

The obvious danger here is FCCN suffers yet another relapse. Yes, there is the chance of a wider high-street slowdown hurting sales, but the crucial risk every clothing chain faces is carrying completely the wrong stock. As FCCN puts it:

“Fashion can be a tough game. It is a fast-paced business requiring constant creative drive in order to keep ahead of customer expectations.”

Though recent signs have been encouraging, I am open to looking like a complete idiot if the upcoming Christmas 2014 trading statement admits FCCN customers went elsewhere for their clothes.

Alternatively, rather than any turnaround, I guess there is good chance that FCCN (like most of its shops) trundles along at break-even for years to come and the share price goes nowhere.

I suppose that outcome could be very likely if Mr Marks ever decides to spend less time looking for top designs but still remains in charge.

Was it Buffett who said “turnarounds seldom turn?”

As I say, this is not a quality buy-and-forget investment, and turnarounds often take far longer than most investors expect. Indeed, FCCN shareholders have suffered many false dawns since the heights of FCUK a decade ago.

Nonetheless, the present signs look promising. New senior staff have been hired, higher gross margins indicate better products and progress has been made on those onerous leases. Finally, my recovery assumptions do not seem extravagant and the unloved share-price might offer plenty of upside if they one day come good.

Until next time, I wish you happy and profitable investing!

Maynard Paton

Disclosure: Maynard owns shares in French Connection.