French Connection Group PLC designs and supplies branded fashion clothing and accessories for men and women. The Company operates in around 50 countries around the world. It operates retail stores and concessions in the United Kingdom, Europe, United States and Canada and also operates e-commerce businesses in each of those territories. Its principal brand is French Connection, which designs, produces and distributes branded fashion clothing, accessories, such as toiletries and fragrances, shoes, watches, jewelry, eyewear, furniture and homeware through its distribution channels: retail stores, e-commerce, wholesale and licensing. Its other brands include TOAST, Great Plains and YMC.
Bull View – Daniel
French Connection has had a torrid time in the last 5 years, losing on average £3 million a year. This sustained period of poor performance has possibly created a buying opportunity in the stock. Looking at the balance sheet as of July 2015, it can be seen that the Net Current Asset Value (Current Assets – Total Liabilities) of the company is £35.9 million. This compares favourably to a market cap of £27.2 million. However, it is important to note two things:
- Inventory contributes £37.1 million towards the NCAV
- Lease obligations of £145 million do not appear on the balance sheet
The value of the inventory for a fashion retail company such as French Connection relies upon consumer tastes and demand, and in the fashion world these change constantly. However, I believe that the risk of a serious write-down (greater than 25%) to the inventory of French Connection remains low due to the strength of the brand (in particular the FCUK branding) and that the current market cap provides a modest margin of safety in the event that a write-down occurred (with a write down of less than £9.9 million, the market cap is still greater than NCAV).
Lease obligations would be considered a large liability if the company were to cease operations immediately. Even if this were to be the case, French Connection maintains stores in very attractive locations throughout the UK and so there is a strong possibility that the company could reassign the leases. In the more likely scenario that French Connection continues to operate, the lease obligations are less of a worry. The company can carry on trading at the more profitable stores, and allow leases to expire at the less profitable locations.
Although the firm is struggling in high street retailing, the wholesale and licensing segments are performing well. If the firm can effectively restructure their retail business, continue their strong performance in wholesaling and licensing, and keep up with the latest fashion trends, then this could be a successful investment. The downside is limited by the healthy balance sheet, but in a return to profitability, the upside could be very rewarding. Currently investors have lost faith in French Connection due to the frustrating performance over the last 5 years, but if strong financial performance returns to the company, the market could potentially apply a healthy P/E multiple to the stock in the future and provide good returns to an investor who buys in today.
I will now offer one final perspective on this investment by assuming French Connection is 3 separate companies; a profitable licensing business, a profitable wholesale business and a highly unprofitable retail business. If you then take the view that they can exit the retail business as leases expire (4-year average lease expiry time) then you will be left with two profitable businesses. These two businesses currently generate operating profit of £21 million – a healthy number for a company with a market cap of £27.2 million. Therefore a sum of the parts valuation would imply the shares are undervalued.
Bear View – Brandon
I will be looking into reasons for not investing into French Connection and try to find out if the market has put the correct valuation on the firm. French Connection is a company that can be split down into 3 key business areas: Retail, Wholesale and Licensing. Two of which provide the firm with profits whilst the other (Retail) is a drain on the firm’s resources.
As French Connection themselves state, a key driver for the company is the ability to produce attractive garments that consumers wish to purchase, this leaves the firm have no long term economic moat. Variations in the success of future collections makes projections of financial performance difficult to make. This is well highlighted in the first half of 2015, with retail operations making a £11.1m loss (£7.5m loss in 2014), French Connection say this was due to the disappointing performance of the spring collection. This is an outcome that has the potential to be recurring thus making the performance of the business variable. Recurring losses will also close the gap between NCAV and share price.
The firms Wholesaling operation made a profit of £5.5m while Licensing made a profit of £3m. These operations I believe would be valued at a strong earnings multiple, a multiple on these earnings would only need to be around 3.2x to reach the firm’s current market cap. This shows that investors have low confidence in the future performance of the Retailing operation. This leads me to question the motives of management, after a number of consecutive years of loss in retail, why hasn’t the business returned to profit or closed the retail operation? I believe that management place too much value on the retailing side of the business and that the retailing operation will continue to erode profits and consequently shareholder wealth. If the firm does return to profit then a healthy return on investment is there to be made, however I believe this is speculative and doesn’t provide a consistent return and thus would advise against any sizeable investment in French Connection.
Large lease obligations are also an important risk. Should the company finally decide to close its retail operations, lease obligations could close the gap between share price and NCAV, reducing the margin of safety in any investment.
French Connection is not a well performing business. We believe, however, that there is an investment case based upon the net assets the company possess. They have a strong brand that under correct management can provide investors value. The company also has a strong balance sheet that provides a margin of safety to an investment. With a floor in the share price that we believe to be around 18p a share and a large yet undeterminable upside that would come with a turnaround in the business, we believe the risk/reward profile is strong enough for a 5% investment in the company. We will regularly review this position as future financial and trading news is released by the company.
Disclaimer – This site is purely for an educational purpose and we do not advise using our analysis as any sort of financial guidance.