Another Retail Roadkill Candidate: Francesca’s

My analysis in the retail space is well documented on this website, as I love the idea of searching through the closet (excuse the dad joke / pun) to find an ugly sweater that I can turn around and wear to a Christmas party and impress everyone there. When it comes to analyzing retail stocks, the most important aspect of the company is its debt levels compared to its cash. Now with every company I look into, I prefer no debt, but an emphasis is placed on no debt in this case because the industry has been hit so hard, companies with any amount of debt could quickly become solvent with the inability to pay their obligations as their margins tighten and sales traffic slows.

When doing my daily look into potential plays, I stumbled across Francesca’s (FRAN). I was initially intrigued by the chart pattern, as you will see later, but the fundamentals are also tantalizing for any self – declared value investor. Before taking a look at the fundamentals, it’s important to see how Francesca’s ended up where it is now. The company’s share price has declined 60% since the start of the year, a significant decline compared to the overall surge in stocks during the same time.

Ya Done Messed Up

Figuring out where FRAN went wrong this year can be found inside the company’s Q2 earnings transcripts. To start the year, the company attributed their rough start to a soft line sales trend. The trend accelerated around Memorial Day, which carried into the summer clearance cycle. Also, the company said that the downward trend continued deep into the back-to-school times of sales.

One thing to keep in mind is that Francesca’s headquarters are located in Houston, and was clearly impacted by the Hurricane, but to the exact extent, the company reported the damages by saying,

“First, we have had most of our boutiques in Southern Texas closed for multiple days over the past two weeks. As the waters have receded we have started to reopen our stores. Fortunately we have only six boutiques that sustained real damage, and even these six are in good enough shape to be operational. As the boutiques reopened, many centers worked on reduced hours, but at this point, all but one are back to open during normal business hours.”

Besides the hurricane impact, the company’s sales continued to trend downward with pressure from declining conversion rates and the overall acceptance that people just weren’t responding to their array of products.

The company identified four main areas in which they dropped the ball to start the year. First, the company suggested that many customers perceived their merchandise as more expensive due to the more heavily weighted skew of products with higher price points. So although the average price of their products as a whole didn’t increase, the ratio between ‘value’ products and ‘premium’ products weighed more heavily towards premium.

The second area in which the company dropped the ball was that the company was focused too much on the younger generation, disregarding the millennial generation which made up most of their sales. Another way of looking at it is that the company switched its focus from customers that want to be fashionable but too forward, and instead shifted the attention to a group that was perceived to be ‘cutting edge’ in fashion trends. This is inherently a less profitable plan because a trend takes a bit of time to get going, and by investing in the early part of the trend, you expose yourself to a trend not working out. In other words, you can think of this as negative asymmetry towards sales.

For its third headwind to start the year, the company claimed that it shifted its focus too much on narrowing their vendor base, which in turn, made many of their products appear similar to that of the big box stores, because they narrowed down their vendors to the same vendors that are used by those big box companies. Because of this, the company believes it lost a bit of its edge in pricing power due to the lack of uniqueness within the company.

The fourth and final reason why the company dropped the ball to start the year, and as a result attributed to its 60% decline was, and I need to quote the earnings transcript here because I can’t really figure out what it means, “we’ve allowed color multipliers to become a larger percentage of our assortment than we had in the past. This has chipped away at our broad and shallow merchandising philosophy and increased the guests’ perception that our selection is narrower in what they have seen in prior years.”

How They Will Fix It

To start, the company is shifting its planning and allocation duties over to another member of upper management, and they have moved digital merchandising under their Head of Boutiques, David Minnix. On top of that, the company became aggressive in marking down many of its products in the back-to-school section to accelerate sales in that category.

Looking forward to their third quarter, the company claimed it would review its Q3 orders and determine which items it would trim from its shipments in order to preserve and cultivate more of a ‘true-to-Francesca’s’ feel in the clothing.

On the topic of being true to brand, the final action the company is taking is an effort to refocus on their core customer. The will do this by,

“ensuring that we’re sticking to our guiding merchandising principles and broad and shallow buying and to focus on providing value and a unique and special product assortment that can only be found at Francesca’s.”

Improvements in Shopping Tech

One of the things I must see in a retail company before pulling the trigger on a buy signal is their ability and willingness to adjust and adapt to the latest technology, and to use that technology to gain a competitive advantage on other retailers (and to scratch the monster that is Amazon).

FRAN is bringing in a beefed up database with customer email addresses and phone numbers. Accompanying their beefed up backend database, the company is updating its POS system, which enables them to capture more of the customer’s data (which, depending on the value you place on privacy) is a good or bad thing for the consumer, but a great thing for the company. To ring in the new system, the company will offer a loyalty program to customers.

Current Fundamentals

If you’re still with me, congratulations for making it, let’s dive into the fundamentals of FRAN. Trading at 7.51 times earnings, 2.32 times book, and 0.55 times sales, FRAN is better than 91%, 42%, and 61% of its competitors respectively.

FRAN has no debt and a ROIC of 49.54% compared to its WACC (Working Average Cost of Capital) of 3.03% . Looking at margins and growth, FRAN has solid numbers. Operating margins are sitting at 11.90%, Net margin is 7.28%, which I believe has the ability to venture into double digits if their implementations work out. ROE is 32.65%, ROA is 19.27%, and Return on Capital is 59%. Three year revenue growth is 17.90%. All of these metrics are better than at least 80% of its competitors in its industry.

The Charts

Taking a look at the charts you can see that FRAN appears to be making a basing reversal move, as price broke through its descending price channel. Remember that breakouts from diagonal resistance barriers are not as positive of a sign as a horizontal break, but nevertheless it is still a divergence from a downward trend.

Looking at the charts, I like the 7.67 price level for an entry. Right now, price could pull back to the previous resistance diagonal barrier which is now new support, before heading back upwards.

Stop losses would be set at 6.69 or 6.30, depending on your risk tolerance or position sizing.

Closing Remarks

A buy signal will only be initiated if the company shows signs of improvement in sales conversions, and I want to see if the company’s advancement in technology is paying off and not becoming an unwanted liability.

Third quarter results will paint a clearer picture, but for right now, if price hits 7.67, I will initiate a starter position and look to pyramid on good news.

 

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