Francesca’s Holdings

Looking for a new company to invest in, I decided to do another screening on Financial Times’ website during the first week of this month. I wanted to find companies with good returns on equity, growing earnings, low debt, and that recently had their share price pummeled. The criteria I used were:

  • market capitalisation above £5m;
  • total debt to capital lower than 25%;
  • 5 year earnings per share (EPS) growth above 10%;
  • 52 week price change below -50%;
  • 5 year return on equity (ROE) above 15%;
  • trailing twelve months (TTM) price to cashflow (PCF) ratio lower than 8.

Of the six companies this screener returned, the one that I most liked (after briefly reviewing the FT profile and financials for all of them) was Francesca’s Holdings.

Profile

Francesca’s Holdings Corporation is a specialty retailer operating a chain of boutiques across the United States, and offers apparel, jewelry, accessories and gifts. As of July 29, 2017, the company operated 692 boutiques and its ecommerce website. According to its FT profile, it has a market cap of $251.27m, no debt, a 5 year EPS growth rate of 15.77%, a 52 week price change of -57.65%, a 5 year ROE of 45.12%, and a TTM PCF of only 4.48, giving me a cashflow yield above 22%! Looks like a dream company, so let’s take a look at the most recent quarterly statement…

2017 Q2 Report

Pros

  1. No long term liabilities except for landlord incentives and deferred rent of $38m, having decreased by $0.5m from Q2 2016 (quarter-on-quarter) (page 3);
  2. Shareholder’s equity of $115.5m, increasing 16% qoq (page 3);
  3. Net sales increased 3.9% qoq and gross profit increased 2.7% qoq (page 4);
  4. Weighted average shares outstanding decreased 6% qoq (page 4);
  5. Repurchased $15.5m worth of stock during the first half of 2017 (page 5);
  6. Available revolving credit facility of $75m with Royal Bank of Canada, with an option for $25m more, maturing on August 30, 2018. At July 29, 2017, there were no outstanding borrowings under this facility (page 9);
  7. Share repurchase programme of $100m approved on March 15, 2016, with no expiration date. 1,122,000 shares were repurchased at an average price of $13.38, for a total of $15m, during the first half of 2017. Of these, 513,000 shares were repurchased in the second quarter at an average price of $11.16. At July 29, 2017, there was a balance of $48.7m available for future share purchases (page 10);
  8. Decreasing minimum future rental payments under non-cancellable operating leases from $47m in 2018 to $32m in 2021 (page 11);
  9. Deploying a new order management and CRM system to enhance visibility into customer’s preferences, products and supply chain, while continuing to run the existing platform to ensure continuity during the conversion process (page 13);
  10. 21 new boutiques opened during the first half of 2017 (page 14);
  11. Gross profit margin of 46.3%, operating profit margin of 10%, and net income margin of 6% (down from 9.2% in the first half of 2016, but still higher than most retailers) (page 14);
  12. $33.3m of cash and cash equivalents available (page 16).

Cons

  1. SG&A increased 18% qoq, outstripping sales and gross profit growth (page 4);
  2. Net income decreased over 30% qoq to $7.2m (Q2 2016: $10.6m), mainly due to the large increase in SG&A expenses, and to $11.6m from $17.7m in the first half of 2016 (page 4);
  3. Cashflow from operating activities decreased to $8.5m from $25.5m during the first half of 2016, primarily due to higher income tax payments and lower net income, partially offset by timing of payments for inventory purchases (page 6 and 17);
  4. Stock based compensation expense of $2.4m in the first half of 2017, compared with a $2.6m reversal of previously accrued stock based compensation in the first half of 2016 due to the prior CEO’s resignation in May 2016 (page 10);
  5. Hurricane Harvey affected the company’s headquarters, ecommerce fulfilment and distribution facilities, and forty boutiques in August 2017. As of September 5, 2017, all facilities except one boutique had been reopened. The disruption to the supply chain was expected to take a couple of weeks to normalise (page 11);
  6. The increase in selling, general and administrative expenses to $43.5m for the quarter was due to a $1.3m increase in corporate and boutique payroll, $1.2m increase in professional service fees and software costs, $0.5m in new stock awards, and $0.4m in marketing expense. The prior year amount includes a $2.0m benefit due to the prior CEO’s resignation (page 14).

Finding 12 Pros and half as many Cons, and realising that this is a good company with a pristine balance sheet (no debt and no goodwill) that is buying back shares but is experiencing a temporary reduction in cashflow and net income (due to Hurricane Harvey, increased SG&A costs and others), I decided to proceed and read the latest annual report.

2016 Annual Report

Pros

  1. Only 80 pages long!;
  2. 671 boutiques as of January 28, 2017 (page 2);
  3. Opened 64 new boutiques and closed 9 underperforming boutiques in 2016 (page 4);
  4. Broad assortment appeals to women of varying ages and diverse backgrounds, but core guest is a fashion conscious woman between the ages of 18 and 35, who tends to be college educated, and has moderate to high disposable income (page 4);
  5. The company carries a broad selection but limited quantities of each style and delivers new merchandise to boutiques five days a week, contributing to a sense of scarcity and newness, mitigating fashion risk, reducing seasonality of the inventory and protecting margins (page 5);
  6. Top 10 vendors sourced 30% of the company’s merchandise, with no single vendor accounting for more than 6% of purchases (page 5);
  7. 299,996 shares were bought between October 30, 2016 and January 28, 2017 at an average price of $17.33 for a total of $5,198,930.68 under the current share purchase programme (page 30);
  8. Net sales have increased every year from $296m in 2012 to $487m in 2016, growing at about 13% per year, a 64.5% total increase in five years (page 32);
  9. Net income has increased in the past three years, from $32m in 2014 to $42m in 2016, a 31% increase (page 32);
  10. Weighted average diluted shares decreased from 44,807,000 in 2012 in 38,551,000 in 2016, a decrease of about 14% (page 32);
  11. Equity increased from $72m in 2012 to $116.5m in 2016, an accumulated increase of about 62%, for a compounded annual growth rate of about 13% (page 32);
  12. Return on equity of 36%! ($42m/$116.5m=36.05%)in 2016, having ranged between 30% and 65% in the past 5 years (page 32);
  13. Ecommerce sales increased from $14.4m in 2014 to $24.1m in 2016, a compound annual growth rate of about 29%. They were 3.8% of total sales in 2014, and 4.9% of total sales in 2016 (page 34);
  14. 46.9% gross profit margin and 8.6% net income margin in 2016, decreasing slightly from 2015 but still higher than most retailers who are selling for higher PE ratios (page 35);
  15. Operating cashflow was $72m, $63m and $54m in 2016, 2015 and 2014, respectively. Free cashflow (FCF) was $50m, $39 and $30m, which means the company is selling for 5x 2016 FCF, and for 6.3x average FCF for the last three years (page 38);
  16. Net cash used in financing activities in 2016 was $53.3m, mainly for repurchasing common stock (page 39);
  17. Revolving credit facility of $75m, with an option to increase it by $25m, entered into with Royal Bank of Canada and maturing on August 30, 2018. As of January 30, 2017, no amount was outstanding under this facility (page 40);
  18. The only long term liabilities are landlord incentives and deferred rent, which was $38m in 2016 (page 46);
  19. EPS increased 43.4% in the last two years (page 55);
  20. A total of $53m was spent to repurchase 3.8m shares at an average price of $13.98 during 2016 (page 58);
  21. There were 467,000 stock options outstanding at an average exercise price of $16.96, and 436,000 non-vested restricted stocks at an average grant date fair value of $15.86, as of January 28, 2017 (the option holders do not make any money until the share price rises above $16.96, and it currently stands at $6.97) (pages 60 and 61).

Cons

  1. Net sales per average square foot decreased to $545 in 2016 from $632 in 2012. For the last three years, they have remained flat (page 7);
  2. Success depends on the company’s ability to anticipate, identify and respond quickly to new and changing fashion trends (page 11);
  3. Extensive ass covering with 17 pages discussing several risk factors in high detail, including the one above. It’s a retail company, and it’s subject to intense competition, supply pressures, growth challenges, economic conditions, geographic limitations (in that its headquarters and single distribution facility are located in Houston, Texas and may be vulnerable to extreme weather conditions), real estate changes, technological disruption, system security risk issues, changing labour regulations, and others. Then again, all annual reports discuss risk factors (page 11 to 28);
  4. Net income has decreased from $47m in 2012 to $42m in 2016, a 10.6% decline, but has increased since 2014 when the company earned only $32m (page 32);
  5. The business is seasonal, with demand being highest in the fourth fiscal quarter and lowest in the first fiscal quarter, which might explain the share price pattern in the last three years (with support around $10 in the first quarter and reaching $20 or more in the fourth quarter of each year (page 37);
  6. Capital expenditures for 2017 are expected to be $28m to $33m (much higher than the $24m average for the last three years) for investment in new and existing boutiques, and implementing a new point-of-sale and CRM system (page 39);
  7. Average income tax rate was 38% for the last three years (page 57);
  8. As of January 28, 2017, there was about $4.6m of unrecognised compensation cost related to non-vested stock awards that is expected to be recognised over the next two years (page 61).

Conclusion

This is a very good company with rising sales, excellent returns on equity and no debt. It’s repurchasing its own stock (with $47.8m still to be used in the share repurchase program) and selling for 5x its 2016 cashflow. Right now it’s experiencing some cost pressures due to its seasonal business (most profits are made in the fourth quarter), Hurricane Harvey, opening new boutiques, investing in IT, and increasing its SG&A, so it is very likely that net income and cashflow will be much lower in 2017, which is probably why its share price has declined over 50% in the past 12 months. Even so, I would expect the share price to increase during the fourth quarter (as it has done in the last three years) and costs to become more normal in 2018.

For all the above, I placed Francesca’s Holdings in the ‘Yes’ tray.

Stay tuned for my valuation on FRAN.

One thought on “Francesca’s Holdings

  1. Pingback: My second investment – Investing: Move by Move

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