The Francesca's Turnaround: Not Worthy Of Its Price Action

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About: Francesca's Holdings Corporation (FRAN)
by: Detroit Bear
Summary

Shares of Francesca's are up over 150% after the company posted a surprising Q2 profit.

Still, comps and gross margin were down while the company failed to appropriately clear inventory.

Although the move is exciting, I believe its a function of a low float and high short interest rather than genuine excitement about the business.

I remain on the sidelines due to Francesca's poor balance sheet and sales that remain negative.

Shares of Francesca’s (FRAN) have been rallying, up over 150% in just two days after the company posted a significantly better than anticipated second quarter, marked by a 5% decline in comparable sales, ending a trend of 7 straight quarters of double digit comp declines. Without question, second quarter results were far better than I anticipated given the recent management turnover, poor balance sheet, and stale inventory.

Overall, the second quarter looks like an unexpected positive. However, I do not believe second quarter results warranted a more than doubling of the stock price. Let’s take a look at the technical factors that likely drove the stock, as well as the current financial state of the company, and the success of its turnaround plan.

A Low Float and a High Short Interest = Volatility

Before I even touch upon Francesca’s fundamentals, there are a few technical factors that have driven the move. The first factor is the low float. Francesca’s has only 3.1 million shares outstanding after the company did a reverse split in July to remain listed on Nasdaq, and of the 3.1 million shares, 1.22 million were held short as of August 14th. In aggregate, this translates to a short interest in excess of 40%.

With such a high short interest and such a low float, Francesca’s stock is ripe for volatility, and in this case, I believe massive short covering is a primary culprit of the upward move in the share price.

Financials Improved But Are Not Great

Without question, Francesca’s operating performance in Q2 improved relative to Q1. Net sales fell 6% y/y to $106 million with comp store sales down 5% y/y as Francesca’s shutters its least productive locations. Here’s the kicker – Francesca’s continued to use discounts to clear inventory, however, its gross margin fell only 80 basis points y/y to 38.2% of sales, with merchandise margin only down slightly. Admittedly, Francesca’s gross margin was nearly 44% in FY17, but Q2 was the first indication that Francesca’s bleeding may stop.

Even more surprising, one of Francesca’s core product lines, jewelry, grew sales 4% y/y in the quarter, though other key categories like apparel (-8%), accessories (-6%), and gifts (-25%) continued to decline. Management provided significant detail on the company’s updated buying strategy and how it was improving performance, saying:

“We are operating fully as a demand-based read and react business model to deliver a broad and shallow trend right assortment. We have accomplished this by employing simplified planning and buying principles, conducting weekly sales meetings to analyze selling trends, maintaining approximately 50% open to buy available on a monthly basis to chase into strong selling merchandise and reducing lead times down to on average between one to twelve weeks. These measures have provided us with the knowledge nimbleness and flexibility to successfully execute a fast fashion strategy.

The teams consistently look at best and worst sellers of the sell-through, margin and inventory position level weekly. They then react to future on order by advancing repurchasing, reducing, and adjusting through cancellations of product based on deep data analytics.”

Although none of these tactics are completely revolutionary, it does appear that the company is improving execution. Management noted that even dresses and shorts posted positive comp sales growth after a prolonged period of double digit declines.

On the cost side, management cut spending significantly, with SG&A down 10% y/y to $39.1 million, reducing it as a percentage of sales by 140 basis points, and ultimately leading to some fixed cost leveraging even though sales declined. Management has identified $8 million in annual corporate and third party costs as well as $7 million in labor reduction costs, and I believe this is beginning to manifest in the numbers.

Overall, operating margin jumped 60 basis points y/y to 1.3%, delivering operating income of $1.4 million. As a result, net income jumped to $0.61 per share, which sounds impressive, save for the fact that Francesca’s has dramatically reduced its share count.

Nevertheless, management is doing a wonderful job of executing on the cost front. I am more pessimistic on sales because comps were still down 5%, but I believe the odds of a sales turnaround look higher than they did a few weeks ago.

From a balance sheet perspective, Francesca’s is sitting on only $22 million of cash, though the company generated about $2 million in free cash flow through the first half of 2019. It is critical to note, however, that the $22 million includes a $10 million revolver drawdown. Although this revolver was paid off after the quarter close, it was paid with a 3-year term loan for $10 million from Tiger LLC. This buys Francesca’s some liquidity, but not a ton.

More importantly, Francesca’s also faces $214 million in lease obligations. Though the company continues to close its least profitable boutiques, the company now still remains severely undercapitalized. Francesca’s continues to have little margin of safety to execute a turnaround.

Ultimately, that is the primary reason why I continue to avoid the stock. Although the company’s market stands at $50 million, the company has less than $25 million in cash and roughly $38 million in total liquidity. Inventory on a per boutique basis was basically flat y/y, meaning future discounts likely remain necessary to clear excess inventory.

Although it is exciting to see such a powerful share price move, I believe the move is mostly a function of the tiny float and high short interest. In essence, Francesca’s sales and gross margin continue to fall while the company deals with tremendous lease liabilities against a backdrop of limited cash and equity value. Overall, I do appreciate the direction of the turnaround; however, I remain on the sidelines due to Francesca’s terrible balance sheet and overstated inflection thus far.

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.