French Connection: I Still Think The Shares Could Top 100p

17 March 2015
By Maynard Paton

Quick update on French Connection (FCCN).

Event: Annual results published 17 March

Summary: Mixed results. The Retail division was subdued, and gave a disappointing second-half performance. However, trading at the Wholesale and Licensing divisions appeared promising. There was further welcome progress on cost cutting, too. This turnaround has still to really turn, and I’ve trimmed my recovery assumptions. But the upside potential remains sizeable. I continue to hold. 

Price: 54p.
Shares in issue: 95,899,754
Market capitalisation: £52m
Click here for my previous FCCN posts.

Results:

 My thoughts:

* These results were somewhat mixed.

True, the £0.8m underlying operating loss was not a great surprise.

However, the performance within FCCN’s Retail chain was a little disappointing — especially during H2 — and I do not expect much in the way of sales progress within this division in the near future.

Nevertheless, the group’s Wholesale and Licensing divisions made positive strides during the year and support the notion of the FCCN brand retaining some appeal.

* Bank balance still supports hope of a recovery

FCCN’s results presentation claimed the average net cash position during the year was £13m. That healthy bank balance, alongside the fact the business is now almost at break-even, continues to provide support for the long-awaited turnaround.

* Retail: Disappointing gross margins

This table summarises the Retail division’s performance:

	H1 2014	H2 2014	FY 2014		H1 2015	H2 2015	FY 2015
Revenue (£m)	55.8	61.7	117.5		49.9	53.4	103.3
Cost of sales (£m)	(24.4)	(26.3)	(50.6)		(21.2)	(23.0)	(44.2)
Gross profit (£m)	31.4	35.4	66.9		28.7	30.4	59.1
Operating expenses (£m)	(39.9)	(38.5)	(78.5)		(36.2)	(34.2)	(70.4)
Operating profit (£m)	(8.5)	(3.1)	(11.6)		(7.5)	(3.8)	(11.3)

Retail revenue fell 12% to £103m — a combination of closing nine loss-making shops and underlying store sales dropping 3%.

H2 looked a tad worse than H1. During H2, revenue dropped 13% (vs 11% for H1) and gross margins came in at 56.9% (vs 57.5% for H1). The H2 gross margin performance in particular was disappointing, given FCCN had been recording notable improvements on this measure during the prior twelve months.

Nevertheless, the closure of those nine loss-making shops helped the division’s operating expenses reduce to £70.4m for the year. The £34.2m figure for H2 suggests retail operating expenses might drop even further during the current year.

* More stores to close

FCCN’s results presentation reveals the average store lease has 4.4 years to run, with “poorer performing stores lower than this average”.  That sounds promising, as does FCCN’s claim that a further 3 or 4 under-performing stores are set to close during the current year.

* e-commerce sales have stalled

Online revenue came to £23.8m, versus £23.5m for last year and £22.2m for the year before. Hardly an ASOS-like performance.

* Retail outlook not great

FCCN says “trading on the high street remains tough”.  Well, I say it depends what you are selling and for how much. Results this Thursday from fellow fashion chain Ted Baker, for example, should make FCCN’s board squirm with embarrassment.

I am not expecting any major store sales improvement at FCCN in the near future.

* Wholesale division: Good progress

This table summarises the Wholesale division’s performance:

	H1 2014	H2 2014	FY 2014		H1 2015	H2 2015	FY 2015
Revenue (£m)	34.1	37.8	71.9		34.1	41.1	75.2
Cost of sales (£m)	(23.0)	(25.3)	(48.5)		(23.0)	(27.9)	(50.9)
Gross profit (£m)	11.1	12.3	23.4		11.1	13.2	24.3
Operating expenses (£m)	(6.1)	(5.6)	(11.7)		(4.9)	(4.8)	(9.7)
Operating profit (£m)	5.0	6.7	11.7		6.2	8.4	14.6

Wholesale revenue advanced 5% to £75.2m and profits gained 25% to £14.6m — all welcome news. Gross margins were flat, though, at around 32%, but I am pleased Wholesale operating expenses have continued to fall despite revenue increasing.

* Wholesale outlook appears promising

FCCN is “encouraged by forward orders in our Wholesale business.”

* Licensing income: Good progress

This table summarises the Licensing division’s performance:

	H1 2014	H2 2014	FY 2014		H1 2015	H2 2015	FY 2015
Licensing income (£m)	2.8	3.3	6.1		2.9	3.6	6.5

The uplift followed greater sales of FCCN-branded shoes and furniture by third parties.

* Lower group overheads

I am pleased FCCN’s central costs continue to reduce:

	H1 2014	H2 2014	FY 2014		H1 2015	H2 2015	FY 2015
Group overheads (£m)	(5.8)	(5.5)	(11.3)		(5.6)	(5.1)	(10.7)

Valuation

* I still believe this share can one day top 100p

Time to revise my valuation sums and FCCN’s recovery potential.

My previous and revised assumptions for what could happen are listed below:

Old assumption	New assumption	Achievable?
Retail sales advance 10% to £123m	Retail sales advance 2% to £105m	£105m-plus reported up to 2014
Wholesale sales advance 10% to £79m	Wholesale sales advance 10% to £83m	£82m was reported in 2012
Retail gross margins advance to 60%	Unchanged	60% was regularly reported up to 2011
Wholesale gross margins advance to 35%	Unchanged	35% was reported between 2011 and 2013
Licence income remains at £6.2m	Licence income remains at £6.5m	£6m-plus was reported between 2013 and 2015
All other operating costs remain the same	Double up FY15 H2 operating costs	Greater sales could mean greater overheads, but the cost base has been reducing every half of late

Perhaps the most important estimates are gross margins — I am still relying on some worthwhile improvements. However, FCCN has at times reported such gross margins during the last few years and so I don’t see my assumptions as being outlandish.  Overall, I am betting more on future margin improvements and cost savings than I am on revenue gains.

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

	Year to 31 Jan 2015		My Projection
RETAIL
Sales (£m)	103.3	Increases 2%	105.4
Gross profit (£m)	59.1	Margin improves to 60%	63.2
Operating expenses (£m)	(70.4)	Double H2	(68.4)
Operating profit (£m)	(11.3)		(5.2)
WHOLESALE
Sales (£m)	75.2	Increases 10%	82.7
Gross profit (£m)	24.3	Margin improves to 35%	29.0
Operating expenses (£m)	(9.7)	Double H2	(9.5)
Operating profit (£m)	12.9		19.4
RETAIL and WHOLESALE profit (£m)	3.3		14.2
Licence income (£m)	6.5	Unchanged	6.5
Common and group overheads (£m)	(10.7)	Double H2	(10.2)
Finance income (£m)	0.1	Unchanged	0.1
Joint-venture income (£m)	0.0	Unchanged	0.0
TOTAL OPERATING PROFIT (£m)	(0.8)		10.6

The £10.6m profit projection compares to the £11.6m I was projecting back in January.

After applying tax at the standard 20%, earnings could be £8.5m or 8.9p per share if my revised guesswork comes good. Then mix in a middling P/E of 12, and I get a prospective market cap of £102m and a share price of 106p.

That looks good upside potential to me with the shares at 54p. As before, the potential returns would be quite respectable if this predicted turnaround can be achieved in less than five years. But as today’s results confirm, the journey is unlikely to be entirely smooth.

* Next update — probably an AGM statement during mid-May.

Maynard Paton

Disclosure: Maynard owns shares in French Connection.