Francesca's: The Risk Looks Higher Than The Reward

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Summary

  • Francesca's two-year stacked comp in Q3 was -32% and it could be more than 30% again in Q4.
  • The company does not understand its customers, hiring outside consultants to figure out what's wrong.
  • Capital allocation has been abysmal, leaving the company in poor financial shape.
  • The potential downside outweighs the reward given management's track record.

Shares of Francesca’s (NASDAQ:FRAN) are down more than 50% since I first analyzed the retailer just under one month ago. After publishing my article, the company posted terrible Q3 results that were compounded by weak Q4 guidance. Same-store sales remain in free fall, and I see no signs of recovery on the horizon. As a result, I believe investors should stay away from the stock. Let’s take a look at what the latest earnings report implies about the company’s future.

Q3 – One of the Worst Stacks I’ve Ever Seen

Francesca’s same-store sales dropped 18% y/y in Q3 2017, setting up the company with an easy 2018 comparison. Francesca’s responded with a 14% drop in Q3’18, generating a two-year stacked comp of -32%. Each store is virtually one-third less productive than they were in 2016.

As any self-preserving management team should try to do, leadership deflected some of the blame toward traffic that was declining in the mid-teens. This was clearly meant to blame the decline on the mall, but I believe it's a failure of execution from Francesca’s. Online sales remain less than 10% of sales, and though online sales grew, management notably did not share the growth rate.

In aggregate, sales fell 10% y/y to $95.4 million even though the company added new stores and saw online growth. In my view, it's crystal clear that the primary issue is fashion related. Apparel sales fell 12% year-over-year, while jewelry and accessories were flat and down 3%, respectively. Management is bringing in outside consultants to teach the company how to speed up reaction times to new trends as well as get a better grasp of trends across different customer touch points. Overall, I believe consultants can add a ton of value – but it typically comes in the form of cost transformations, M&A, integration, adjacency mapping, and other activities where a corporation should not be expected to have a core competency. Alternatively, when a company has to bring in consultants to handle the blocking and tackling of a business, this is bad sign. I see consultant hiring as an explicit omission that management doesn’t understand its customers.

With sales declining precipitously, margins are compressing. Gross margin deleveraged by 430 basis points y/y to 35.3%. Francesca’s claimed a 130 basis point increase in merchandise margin, but it's tough for me to imagine merchandise margin is up when the company clearly has the wrong product assortment.

SG&A was up both on an absolute basis and as a percentage of sales, increasing by about $0.9 million to $42.3 million, or 44.3% of sales. In total, the company’s adjusted operating margin swung from roughly breakeven to -9.1%. Management needs to quickly rationalize Francesca’s cost structure to accommodate for a lower base of sales. Cost transformations are difficult, but I think it will be quite necessary for the company to survive.

In addition to the jump in SG&A spending, the company took $14.4 million in impairment charges for 129 stores that are no longer considered as valuable. 106 of these boutiques have a kick out or lease end in the next three years, which is positive, and the company should be able to close 30-40 boutiques next year, which should help somewhat with profitability.

Q4 and Beyond Not Looking Great

Management took the right action and abandoned prior guidance to admit that Q4 is going to be terrible. Comps will be down 10%-15% on top of a 15% decline in Q4’17. Although the company is moving into some better apparel categories like rompers and jumpsuits, the move feels very late to the fashion party.

In addition to a late move in fashion, the company ended Q3 with per-store inventories just 6% lower than the year ago period. Francesca’s Q3 increase in merchandise margin could be short lived as the drop in sales outpaces the inventory decline.

On the positive side, management did not repurchase any shares during Q3. Like I mentioned in my first piece, I bet management wishes they had engaged in more prudent balance sheet management in the past when they were repurchasing stock without regard for price. Nevertheless, it's positive to see management do the right thing and not buy back stock.

Ultimately, management’s hand was forced by the poor condition of Francesca’s balance sheet. The company ended the quarter with over half of its $75 million asset-based revolver drawn down and just $10.7 million in cash. Francesca’s is quickly losing its flexibility and possibly descending toward the path to bankruptcy if it's unable to dramatically improve its cost structure.

For the full year, Francesca’s anticipates capex spending of ~ $25 million, which will almost undoubtedly result in negative free cash flow for the year. With the company aggressively closing stores in the next few years, FY19 capex is expected to total just $10 million. The company will invest in IT and e-commerce, but frankly, given the company’s capital allocation to these activities over the past few years, I think this spending could be too little, too late. Francesca’s is clearly under indexed for e-commerce relative to peers, but there's a lot of investment capital that goes into making online shopping a great customer experience. Francesca’s barely knows its customers, so forgive me if I have little confidence in the ability to develop a new e-commerce platform.

Stay Away

Francesca’s looked interesting trading below book value with a turnaround story in hand. Now, after multiple quarters of failure, I'm convinced management doesn’t know how to repair the business. Bringing in outside consultants to help Francesca’s understand its own customers demonstrates a poor grasp of the basic skills necessary to run the company. Additionally, capital management has been relatively poor over the past few years, leaving the company with little margin for error on execution. Could Francesca’s workout? Absolutely. However, I think the risk is to the downside at the current share price.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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