Be Careful Betting On The Action At Francesca's Holdings

| About: Francesca's Holdings (FRAN)
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Summary

Specialty retailer Francesca's has had trouble finding profit growth in FY2014, hurt by discounting and promotional activity that has taken a toll on its operating profitability.

The company's relatively poor financial performance has led to a moderate sell off for its stock price in 2014.

With a forward P/E multiple of roughly 20, Francesca's seems to be a risky proposition given its lack of profit growth and investors should probably avoid the story.

Shareholders in specialty retailer Francesca's (NASDAQ: FRAN) have likely not been too happy with the company's stock price trajectory in 2014, down more than 10%. Francesca's has anecdotally been hurt by relatively weak customer traffic flows and a highly promotional selling environment, factors that have combined to take a bite out of its operating profitability in FY2014, down roughly 720 basis points.

On the upside, though, the company has continued to post solid top-line growth, up 8.7%, thanks to a continued expansion of its overall store network. In addition, Francesca's recently landed a new high-profile CEO, the former head of retail jewelry chain Signet Jewelers, a move that the market seems to think will improve the company's profit growth prospects, if the positive subsequent price action in its stock price is any indication. So, after a negative return to-date in 2014, is Francesca's a good bet for investors?

What's the value?

Francesca's is a niche player in the specialty retailing sector, operating a network of more than 500 stores that cater to a target customer base of young adult, fashion-conscious women, with an eclectic mix of apparel and accessories product offerings. The company has taken advantage of generally rising popularity for its brand over the past five fiscal years, which has led to favorable store productivity, with average sales per square foot of roughly $543. The net result for Francesca's has been a consistently profitable business model, helping to fund an aggressive expansion of its franchise around the country and strong top-line growth during that time period, up 328.6%.

In its latest fiscal year, it was a continuation of the growth story for Francesca's, highlighted by a 14.8% increase in total revenues that was a function of double-digit growth in its overall store base. On the downside, though, the company was negatively impacted by lower-than-expected customer traffic volumes, requiring it to engage in more discounting activity in order to incentivize customer transactions, culminating in a roughly 180 basis point drop in its gross margin. Not surprisingly, Francesca's reported declines in operating income and cash flow during the period, bringing into question the wisdom of continuing to expand its store base at such a fast clip.

Looking into the crystal ball

The question for investors is whether Francesca's can find its way back to profit growth in the future, thereby providing a foundation for a higher market valuation. On that score, things don't seem to be looking too good, judging by the company's 25.8% decrease in operating profit during FY2014. As previously mentioned, Francesca's has been hurt by lower customer transaction volumes, leading to greater inventory markdowns and more promotional activity. Worse, management seems to be forecasting the margin pressures to continue going forward, a trend that would seem to make profit growth an unlikely event for the company in the near term.

Of course, Francesca's isn't the only specialty retailer struggling to find profit growth in the current operating environment. Fellow competitor Fossil, Inc. (NASDAQ: FOSL) has also seen a downshift in its profit growth in FY2014 compared to the prior-year period, reporting a 0.6% increase in operating income. Like Francesca's, Fossil Group has maintained solid top-line growth in the current period, up 11.3%, but that increase has come at the cost of margin contraction, evidenced by a 150 basis point drop in its operating margin. More importantly, management seems to be expecting the margin pressures to continue for the foreseeable future, an outlook that doesn't seem to bode well for other sector players, like Francesca's.

The bottom line

Francesca's is a bit cheaper than it was at the start of the year, after a double-digit decline to-date in 2014. However, with a forward P/E multiple of roughly 20, the company is not exactly cheap, given its decline in operating profit during FY2014. As such, while the market may be excited about a new CEO, prudence would seem to dictate that investors should wait for some improvement in Francescas' profit growth trajectory prior to betting on the story.

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.