Francesca's Holdings' Disheartening Decisions

Summary

• Francesca's reported fiscal 2019 fourth quarter and full-year results on May 1st. Some considered the most disheartening factor was the retailer's employment of the "going concern" phrase.
• In the third quarter, it had incurred atypical debt to upsize its inventory levels for the holiday quarter. But the decision turned out to be a poor one.
• The retailer did report its second consecutive quarter of CSS growth. But this was achieved through decreases in AUR prices as a result of deeper markdowns and promotions.
• It seems the last year spent under an interim CEO, a retail performance improvement expert, was a waste.
• And, now, the COVID-19 pandemic has shut down the majority of the retailer's operations.

Investors heaved when Francesca's Holdings (NASDAQ:FRAN) employed the "ability to continue as a going concern" phrase in its fiscal 2019 fourth quarter report. The phrase simply means the business may not be able to pay its financial obligations as they come due.

Francesca's operated debt-free for years. But the interim CEO opted to increase its debt obligation to $18.9 million at the end of the fiscal 2019 third quarter. This was the first third quarter since 2013 where Francesca's had a debt obligation on its books heading into the holiday season. The funds were borrowed under the retailer's August 2019 term loan at an interest rate equal to LIBOR + 8% relevant to the loan period but at least 10%.

The interim CEO, Michael Prendergast, incurred the debt to build inventory for the holiday season.

With sales trends now performing in line or above inventory levels, we identified key categories that we chose to accelerate inventory receipts to benefit our sales. Based on our data analytics, we reacted to customer demand to supply appropriate inventory levels at the right time for holiday. The teams worked diligently with our vendor base to accelerate inventory shipments and shorten distribution time in preparation for the fourth quarter.

According to the balance sheet, inventory increased 19%, by $7.6 million compared to 2018 and by $17 million compared to the second quarter. In the decade, this represented the greatest inventory level at the end of a third quarter.

The inventory build and subsequent borrowing would be Mr. Prendergast's departing gestures. On February 13, 2020, Francesca's announced Andrew Clarke would take the reins on March 9th.

Interim CEO Tenure

Frankly, since the boutique-like retailer conducted its IPO in 2011, there's been a revolving door on the CEO office. Steven Lawrence was its longest-tenured CEO at two years and four months. He abruptly resigned on January 31, 2019. At the same time, the company announced it was exploring strategic alternatives.

Francesca's immediately engaged a Senior Director from Alvarez & Marsal's Private Equity Performance Improvement Retail practice, Michael Prendergast, as an interim CEO. Mr. Prendergast took over on February 1, 2019.

Clearly, decisions were being made well before January 31.

Mr. Prendergast was the sixth person to fill the CEO position in less than eight years.

Date	CEO	President
Year beginning 2012	John De Meritt	Non-existent position
08/01/12	John De Meritt	Neill Davis
01/01/13	Neill Davis	Theresa Backes
01/27/14	Neill Davis	Neill Davis
12/05/14	Michael Barnes	Michael Barnes
05/17/16	Richard Kunes (interim)	Richard Kunes (interim)
09/20/16	Steven Lawrence	Steven Lawrence
02/01/19	Michael Prendergast (interim)

Click to enlarge

Six months later, in August 2019, the company declared its review of strategic alternatives completed. The retailer had obtained a new term loan - the one subsequently used to build inventory for the holiday season.

Following a thorough review process, the board of directors has concluded that the Company will best serve the interests of its stockholders at this time by focusing on the continued execution of its turnaround plan.

In September 2019, Francesca's hinted its Board may be part of its problem. The company's Board suggested it may not have all of the talent or skills needed. Its solution was to consider the possibility of expansion.

As francesca's® continues to execute its strategy to rebuild value for our stockholders, we believe exploring the possibility of adding to our Board of Directors to enhance the Board's overall skillset may be beneficial. At the same time, we intend to adhere to our governance processes as we explore bringing the appropriate new talent and skills to the Board.

Yet, expanding the Board would require additional expense. In my opinion, it seemed illogical the Board would not be considering the possibility of replacing members to obtain different or additional talents and/or skills - especially considering its track record.

In December 2019, the retailer finally decided to search for a permanent CEO.

The Board of Directors has hired an executive search firm to initiate a formal search for a permanent Chief Executive Officer.

It could certainly be argued the exploration of strategic alternatives had to be completed before a permanent CEO recruited. Still, a lot of valuable experience - identifying and addressing problems and defining solutions - was lost in the thirteen months between Mr. Lawrence's departure and Mr. Clarke's start date. This loss of knowledge and experience carried the potential of the company slipping back into disarray. After all, it's certainly happened to the retailer more than once as the door to the CEO office revolved.

Regardless, either Mr. Prendergast or the Board or both had decided Francesca's was ready and positioned for forward movement. Or, so it seemed.

Fiscal 2019 Fourth Quarter and Full Year Results

The market had reacted favorably to the appointment of Mr. Prendergast as interim CEO. But, with the reporting of fiscal 2019 fourth quarter results on May 1st, it sure seemed questionable whether the retailer was any better off.

Revenue in the quarter ending February 1, 2020, was $118.9 million from 711 locations. Revenue in the quarter ending February 2, 2019, was $119.3 million from 727 locations. Thus, the average revenue per location for the fiscal 2019 holiday quarter was $167,280, a 1.9% improvement from the $164,113 in the fiscal 2018 holiday quarter. The improvement was attributable to a 1% increase in CSS (comparable store sales). This was the second consecutive quarter with positive CSS. As well, it was the first time since the fourth quarter of fiscal 2015 and the first quarter of fiscal 2016 the retailer had reported two consecutive quarters of CSS growth. Despite what appears to be improvement, the actual details were disheartening.

The increase in comparable sales was due to higher average units sold per transaction and conversion rates, but was partially offset by a decrease in traffic as well as a decrease in average unit retail prices as a result of deeper markdowns and promotions. (emphasis added)

Remember, the retailer had borrowed funds to increase inventory by $17 million because, supposedly, the data analytics reflected customer demand and, supposedly, sales trends were "performing in line or above inventory levels". But, in reality, the quarter apparently saw less customer demand as evidenced by less traffic. Furthermore, though more units were sold per transaction, it appears to be only because of discounting and price-cutting.

Francesca's started the quarter with $21.2 million in cash and equivalents and $48 million in inventory and ended the quarter with $17.8 million in cash and equivalents and $31.6 million in inventory. The average inventory per boutique at the end of fiscal 2019 was $44,495, a 6+% increase compared to $41,923 at the end of fiscal 2018.

Francesca's did repay $10 million of what it borrowed in the final quarter. So, while it started the quarter with $18.9 million in debt, it ended the quarter owing $8.9 million on its credit facility.

The results of the inventory decision are disheartening because it's hardly a new position for Francesca's. Note the similarities in Francesca's statement regarding CSS in the first half of fiscal 2019.

The decrease in comparable sales for the quarter was the result of lower average unit retail associated with deeper markdowns taken to work through poor performing legacy products. (emphasis added)

Interestingly, Francesca's blames its fourth quarter markdowns for its annual CSS decline of 4%.

The decrease in comparable sales was due to a decline in average unit retail prices as a result of deeper markdowns and promotions mainly during the fourth quarter of fiscal year 2019 as well as a decline in traffic. (emphasis added)

Indeed, gross profit in the fourth quarter declined from 39.3% in fiscal 2018 to 34.6% in fiscal 2019. For the full year, revenue declined 4.8% from $428 million in fiscal 2018 to $407.5 million in fiscal 2019. Further, gross profit declined from 38.1% in fiscal 2018 to 36.7% in fiscal 2019. Net sales per average square foot fell from $404 in fiscal 2018 to $390 in fiscal 2019.

Another disheartening factor about the retailer's performance in the fourth quarter, the holiday quarter, is the lack of profitability. Many retailers count on the holiday quarter to move from loss to profit. In actuality, Francesca's revenue in the holiday quarter, at $118.9 million, was only 12% greater than its second quarter at $106 million.

Through the first three quarters of fiscal 2019, Francesca's had reported an adjusted loss of approximately $2.60 per share. For the fiscal 2019 fourth quarter, Francesca's reported an adjusted loss of $0.31 per share, 2.4 times greater than the adjusted loss of $0.13 per share in the last quarter of fiscal 2018. For the year, it reported an adjusted loss of $3.26 per share, 4.8% greater than the adjusted loss of $3.11 per share in fiscal 2018.

On a GAAP basis, the adjusted loss in fiscal 2019 was $8.63 per share compared to an adjusted loss of $14.12 per share in fiscal 2018. The company recorded asset impairment charges in fiscal 2018 of $20.1 million related primarily to the property and equipment on 153 underperforming boutiques. In fiscal 2019, it recorded additional asset impairment charges of $11.9 million related to operating lease right-of-use assets on 60 underperforming boutiques. The property and equipment value changed in fiscal 2018 from $87.7 million to $71.2 million. At year-end fiscal 2019, property and equipment is valued at $51.5 million or an average of $72,390 per boutique. The operating lease right-of-use asset value changed in fiscal 2019 from $230.9 million to $208.5 million.

The disheartening decision relative to these impairment charges is Francesca's closed only 21 boutiques in fiscal 2019 despite identifying 153 underperforming boutiques in fiscal 2018 and 60 in fiscal 2019. It closed 26 boutiques in fiscal 2018.

While the retailer, obviously, continues to have sales challenges, it did manage to save $14.7 million in SG&A expenses in the year. Furthermore, the retailer spent approximately $2 million on professional fees and approximately $3 million on severance benefits, and its turn-around plan that should not recur in fiscal 2020.

Perhaps the most disheartening aspect of the report was the commentary from the new CEO.

Looking back at our fourth quarter results, while performance was disappointing, I believe that we can course correct through improved execution and greater discipline. (emphasis added)

This would certainly imply Francesca's Board wasted a year of expensive fees on an interim CEO that did not correct its course. Apparently, by both the numbers and observation, there was not enough improvement in execution, if any at all.

Ultimately our success will be contingent on creating a customer-centric organization that employs the agility and discipline necessary to react to changing fashion preferences as well as customer demand across channels. (emphasis added)

Supposedly, an agile organization reacting to changing fashion preferences and customer demand was exactly the model Mr. Prendergast implemented in the "turn-around plan".

I believe that with the right strategic direction, a cohesive and experienced management team and commitment to operational excellence, we can deliver on the long-term potential of the francesca's brand. (emphasis added)

So, the message to shareholders, as the seventh CEO in nine years takes the helm, appears to be the company is still operating under the "wrong" strategic direction and still needs to define the "right" strategic direction. It still does not have a cohesive and experienced management team employed. And, it continues to lack a commitment to operational excellence.

Fiscal 2020 To Date

The COVID-19 pandemic, obviously, derailed the retailer's operations. It shut the doors to all boutiques on March 25th, more than halfway through its fiscal 2020 first quarter.

Subsequently, it temporarily furloughed the majority of its employees. Salaries of its senior leadership team were reduced. It halted payments to the majority of its suppliers. It is deferring rent payments. At year-end fiscal 2019, it owed $10.8 million in accounts payable, $48.7 million on current leases, and $12.4 million in other accrued liabilities. Combined with the $8.9 million in debt, Francesca's current liabilities total $80.9 million.

As mentioned already, it had $17.8 million in cash and equivalents at year-end fiscal 2019. It also had $17.2 million available to borrow under its credit facilities.

Since February 1, 2020, the retailer has applied for a $10.7 million tax refund and borrowed $5 million against its revolving credit facility. The company is required to use the tax refund to repay "outstanding borrowings".

The retailer has maintained its e-commerce presence throughout the quarantine and stay-at-home orders. However, e-commerce sales accounted for only 9% of the retailer's revenue in the past two years, equal to less than $37 million in fiscal 2019. If this were to track similarly for the first quarter of 2020, e-commerce revenue would generate less than $10 million. Even if online sales improved 10% in the quarter, e-commerce revenue would not likely top $10 million.

In its May 1st report, Francesca's mentioned it is slowly reopening boutiques as local conditions have allowed. But it is important to recognize the fiscal 2020 first quarter ended May 1st, 2020.

Takeaway

I've not been a fan of Francesca's since first covering it in 2012. My initial takeaway was that the retailer's plans to have 900 stores by 2020 would never come to fruition. It, subsequently, bumped that goal to 1,000 stores.

I've consistently maintained it would never become a mall mainstay by 2020.

If the retailer does not have the ability to continue as a going concern, history may attribute its demise to the coronavirus pandemic. It won't be the truth.

Analyst’s 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.