Francesca's - All Focus On The Rebound Led By Incoming CEO Barnes

| About: Francesca's Holdings (FRAN)
This article is now exclusive for PRO subscribers.

Summary

Investors in Francesca's forgave the company after it reduced the outlook for the third time this year.

All eyes are on the future, with investors hoping for a turnaround led by incoming CEO Mr. Barnes.

The strong balance sheet and still solidly profitable operations create safety and support for the shares during the turnaround.

Francesca's (FRAN) reported its third quarter results this week, which did not contain any big surprises since the company already pre-released its numbers when announcing its new CEO last week.

As a result of the CEO transition, investors have not been too disappointed with a soft fourth quarter earnings outlook as they anticipate a recovery of the company under the command of incoming CEO Barnes.

Third Quarter Sales Results

Francesca's reported a 9% increase in third quarter sales, which rose to $87.1 million. While this looks good, comparable sales for the company's existing stores were actually down some 6% versus last year.

The company opened just 12 new boutique stores during the quarter, for a total of some 87 stores year to date. As a result, the company now operates some 538 stores. To illustrate how "boutique" the business really is, check out average sales per store, which came in at just about $162,000 per boutique for the quarterly period.

A bright spot are the direct-to-consumer, or online sales, which rose by 53% on an annual basis. Unfortunately the company did not specify how large these online sales were, as the growth slowed compared to the 76% growth reported so far this year.

Margin Compression

The fall in comparable sales did not bode well for margins. Gross margins reported for the quarter fell by 340 basis points to a still-impressive 47.3%. The fall in gross margins can roughly be half attributed to the deleveraging of sales, resulting from falling sales per store, while pricing pressure and higher markdowns can explain the other half of the margin compression.

At the same time, operating expenses grew much quicker than headline sales. Selling, general and administrative costs totaled 34.2% of sales, which is 180 basis points higher compared to last year as a result of the greater store base and lower sales per boutique, as well as investments made to support direct-to-consumer sales growth.

Operating margins fell a whopping 520 basis points to a still very attractive 13.1% of sales. The modest topline sales growth could not offset the impact of margin compression, with operating earnings being down roughly 22% to $11.4 million.

Soft Holiday Quarter

For the final quarter, Francesca's sees further margin pressure with gross margins being down some 475 to 525 basis points versus last year's final quarter.

Weak pricing as well as a 5% to 10% drop in anticipated comparable sales are expected to drive this margin compression. The rapid pace of overall store openings compared to last year allows for an overall 4% to 11% expected increase in revenues.

This guidance translates into anticipated sales of $96 million to $102 million for the quarter. Earnings for the quarter are seen between $0.13 and $0.19 per share excluding costs related to the CEO transition, as the company anticipates to open just one store.

Analysts have been disappointed by the guidance for the holiday quarter, having anticipated earnings of $0.27 per share on sales of $104.1 million, based on the assumption of a 2.8% drop in comparable sales.

Clean Balance Sheet, Fair Valuation

Francesca's continues to operate with a strong balance sheet despite the rapid pace of store openings. The company holds $23 million in cash and equivalents, with no debt outstanding. Inventory levels of $35 million were up 16%, actually down a bit on a per store basis.

With little over 42 million shares outstanding trading at $15 per share, equity in Francesca's is valued at $630 million, with operating assets valued around $610 million after backing out net cash holdings.

This values operating assets at 1.6 times anticipates sales of $369 million this year. Based on anticipated earnings of $33 million, excluding CEO transition charges, operating assets are valued at 18-19 times earnings.

The CEO Change

Michael Barnes, who was named CEO of Francesca's a week ago, is disappointed with the results for the past quarter. That said, Barnes remains optimistic about the future of the brand, although of course he would not have taken the job if he was not optimistic.

Barnes said he is still evaluating the business, and upon completion of that, he wishes to create a foundation for growth. He also said the diversified and differentiated merchandising strategy, the small boutique format and growth makes him optimistic about the potential for the brand and company in the long run.

Barnes succeedes former CEO Neill Davis. Previously, Barnes was CEO of Signet Jeweler (NYSE:SIG). Following the $1.5 billion purchase of Zale's, he created a huge specialty jewelry retailer, creating a lot of shareholder value in the process. Prior to that, he played an important role in growing Fossil (NASDAQ:FOSL) into the business it is today.

Final Thoughts

Francesca's has disappointed its investors in a big way this past year, having issued three separate reductions to its full year outlook. The company, which went public in 2011, has been in favor with investors, trading at levels around $30 in both 2012 and 2013. The bad news shows the slump in comparable sales hit the shares hard this year. Shares started the year around $20, and fell to just $11 in October, not having joined the general rally in the retail sector amidst the poor operational performance.

The appointment of Michael Barnes has resulted in a big jump in the share price at the start of this month, as investors really do not care much about the soft fourth quarter outlook as they look forward to the impact of Mr. Barnes's actions. Despite the troubles, Francesca's remains profitable, and actually trades at a fair valuation multiple with a very strong balance sheet and relatively solid inventory levels.

The key is to restore profitability to the flat margins reported in recent times while recovering comparable sales growth. Net after-tax margins, currently coming in around 5% of sales, came in at around 10%-15% over the past few years, which creates real appeal for investors if Barnes is able to turn the business around.

As such, I remain cautiously optimistic as the valuation and balance sheet provide support while the company focuses on its turnaround. The relative risk-reward appeal remains appealing in my eyes for those with patience and confidence in the turnaround of the business.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.