|Shares Out. (in M):||46||P/E||30.9x||26.4x|
|Market Cap (in $M):||1,415||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-2||EBIT||73||88|
I am recommending a short position in Francesca’s Holdings Corporation (FRAN). Trading at ~23.4x LTM EBIT, I believe the Company is fundamentally overvalued and represents a compelling short opportunity with a medium term catalyst on a “free option” that something more nefarious is going on with their two largest suppliers (19% of purchases), both of which are related parties. I believe it is important to understand why FRAN is overvalued on the fundamentals, and why the fundamentals are likely unsustainable. I’ve tried to be thorough in laying out that case, but if you don’t care I’d skip to the part on margins and related parties further down. On a fundamental basis, I believe the Company is overvalued and priced for perfection due to the following:
These points mean the FRAN growth story runs out of gas eventually and it will be difficult for them to sustain this growth and at this multiple. Additionally, as I will discuss later, I believe there is some chance that FRAN’s related party purchases are materially higher margin and are overstating the true profitability of a retailer of this quality. I believe investors shorting FRAN essentially get a “free option” on related party transactions getting reset materially lower. If I am wrong and this doesn’t materialize, it still strikes me as unlikely this business grows into its multiple and there are numerous ways to win. If related party margins are indeed inflated and are reset lower, I’d expect FRAN to trade as low as $7/share. In the case where the Company continues to grow, I believe FRAN is worth $35/share, which is only a slight premium to today’s price.
Francesca’s Holdings is a specialty retailer in the United States targeting the 18-35 year-old fashion conscious female. Retail locations are designed to feel like independent, upscale boutiques and store level “partners” have great autonomy in sourcing product for their store. The Company targets the “low end of the high end” and provides quality apparel, jewelry, gifts and accessories at affordable prices. In FY 2012, as a percentage of annual sales apparel was ~51%, jewelry 20.5%, accessories ~16%, and gifts 12.5%. While the Company does not break out margins by product category, they have disclosed that jewelry is the highest margin category and gifts are the lowest margin. As of 7/28/12, the Company operated 357 stores averaging roughly 1400 square feet per store and approximately 55% of the stores being street locations versus 45% mall-based. The Company was purchased by CCMP in February 2010 and was taken public in July 2011.
Critical to the Company’s business strategy is to provide a “very broad and very shallow” assortment of products with new products arriving five days per week. This high turnover and shallow selection create a sense of scarcity and newness for their customer and leads to increased frequency and customer loyalty. The Company essentially chases fashion trends that are working at other retailers and buys limited quantities from a several vendors. By leveraging vendors off each other, they are able to purchase at prices that “work [for their] margin structure” and by creating a sense of scarcity, the Company can sell more merchandise at full price.
In short, this is a copycat retailer that tries to leverage vendors off each other for better pricing and then trick consumers into buying the trends that are already working by only supplying five of everything. And, they intend to be larger than Anthropologie, Ann Taylor and White House / Black Market (all stated competitors) COMBINED in the next 5 to 7 years…
Store Growth Plans
While there is no doubt FRAN has grown stores dramatically since FY 2009 (111 to currently 357), the next several years of FRAN growth will prove to be much more difficult. The Company was a modest grower prior to the IPO and like all IPOs store growth was accelerated just prior to going public to make numbers look better. But, there is no doubt that the
economic returns on new stores have been strong. The Company cites 150% cash on cash returns in the FIRST year of a new store opening. For those of you reading this who just thought about your investment performance this year, no, FRAN does not franchise. I believe FRAN’s store growth plans are overly optimistic and returns are likely to be lower going forward due to several factors:
What seems obvious here is that no concept made it to 900. In fact, Ann Taylor and WH/BM both stagnated at ~300 and Anthropologie is only ½ of FRAN.
FRAN’s store growth plan of 900 stores seems overly aggressive given none of their comps have come close. It is also worth noting they have accelerated this timeline since the beginning of the year. The 10-K from 1/31/12 said it would take 7-10 years. Moreover, I do not think their competitors will be sitting still as FRAN tries to dominate the boutique women’s apparel universe and their claims of 900 total locations will have to be divided amongst the industry. To put the 900 stores in perspective, Gap, Old Navy, and Banana Republic have 1043, 1016, and stores in North America, respectively. Would anybody call these retailer’s growth plans a success or argue that they achieved great financial returns? More importantly, isn’t having 900 stores in conflict with a retailer that wants to have the feel of an independently owned boutique? Something has to give, and I’m guessing it is either FRAN’s store growth plans, store returns, or both.
Comparable Store Sales
Wall Street analysts love FRAN because of its incredibly high comps which have averaged ~12.9% over the past 6 quarters. However, all comps are not created equal. I believe FRAN’s comps are artificially inflated because of their aggressive store growth. Because it takes stores years to mature and FRAN places stores in their comp base on the first full month following the 15th month after opening, FRAN’s comps reflect the normal progression of a store from fledgling to mature, and not what mature stores are growing at annually. The analysis below, while not perfect because of the monthly timing of store openings, shows the FRAN “comp base” as being relatively stagnant in age over the past several quarters. In fact, over the past 27 months, FRAN’s comp base has aged from ~26 months to ~37 months, so the comp base has increased 11 months in what would otherwise have been a gain of 27 months. This may not sound like a lot, but for a new FRAN store ramping up, stores between years 1 and 3 of maturity will comp faster than mature stores over time. Right now, newer and older stores are comping in a relatively tight band, although new stores are outperforming. This phenomenon is true of all retail; it is just that FRAN is one of the few in retail growing so fast that is it obscuring the statistic and leading to potentially inaccurate conclusions about growth prospects by industry analysts.
While store growth will continue to benefit comps, I believe that the true health of FRAN is being overstated and a slowdown in store openings is likely to impact comps materially as well. To be clear, I am not expecting comps to fall off a cliff any time soon absent a more pronounced economic slowdown. I just think that the multiple that FRAN gets because of its comp store sales growth is too high because these comps are not sustainable.
Gross and Operating Margins
FRAN’s gross margin and operating margin are unsustainably high and are among the highest in retail. I believe that as time progresses and the Company’s competition increases, margins are likely to fall substantially. On an LTM basis, FRAN has achieved gross margin and EBIT margin of 53.1% and 24.2%, respectively. As the exhibit below illustrates, these margins are not only higher than their direct competitors, but materially higher than even some of the best names in retail.
While gross margins are difficult to compare directly, in the notes above I’ve attempted to highlight some of the key reporting differences between the companies listed. Key differences include where a company classifies rent, warehousing and distribution expenses, and where companies record depreciation and amortization. For these reasons, it is more worthwhile to compare FRAN operating margins to those of its peers. Here, the numbers are staggering as FRAN’s full year operating margin was more than double the average of its competitors. So why might FRAN’s margins be so high? I can think of a few reasons:
Does this really make sense? While I understand that businesses can grow via word of mouth and the boutique feel is important, I have a hard time that believing FRAN can grow to 900 stores and fight off competitors without even the minimum spend on advertising. If it were so easy to connect to consumers using only Twitter and Facebook, wouldn’t everybody be doing this? Needless to say, while FRAN’s margins are higher now because of no advertising spend, I would expect them to either spend more on advertising in the future to sustain their business or I’d expect their business to suffer as competitors are able to attract more customers.
Before I get to detail on related party suppliers below, it is worth taking a bit of a step back. Here are a few excerpts from recent investor conferences and conference calls:
“Our ability to successfully chase these trends produced outstanding financial results. I would now like to take a minute to talk about our ability to chase these trends, and to make a distinction about our business model, compared to what is typically called fast fashion. We are better described as fast followers. As fast followers, we identify main stream trends versus emerging trends, which is one distinction. We then source these trends from hundreds of domestic vendors, and deliver it to our boutiques in a relatively short time frame. We also typically buy merchandise for delivery, no more than 90 days out. This gives us the unique ability to source merchandise on a practical, real time basis. So as trends become main stream, we use our available near-term open-to-buy to follow these trends. Another major distinction is that we buy these trends in very limited quantities for each boutique. This allows us to turn the merchandise quickly, and to continuously search -- source new merchandise. This merchandising strategy mitigates fashion risk, because of the limited depth in any one style. It creates an urgency to buy because of scarcity. It encourages return visits because of constant newness. And most importantly, it generates high margins because of greater sell-through at full price.” – Q1 2012 Earnings Call – 06/07/12
“It is really leveraging the vendor base off of each other. So the product that we are buying, again, we are chasing the trend, so it is already in-production product that is out there in the marketplace. And so we leverage the vendors essentially off of each other. So if one vendor is -- and again, because we don't need to buy quantities that would fulfill all stores, because of our merchandising strategy, we can go to a particular vendor that may have 1000 units of a particular style or a top. We'll use that as an example. And we may need to cost that at, we will say, $8.00. And they maybe say, no, this is a $9.00 product. And we will say, well, we need to purchase it at $8.00. That is to give us the margin that we want to have our IMU.” – Jefferies Consumer Conference – 06/18/12
Really? Their “ability to chase the trend?” So here we have one of the highest margin retailers out there that is just a copycat, spends no money on advertising, and leverages hundreds of vendors off each other to get prices that work for them. Is it really that easy? Is this really the iPhone of retailing? If so, won’t everybody just start chasing retail trends and nobody will ever innovate in terms of fashion ever again? We are destined for retail communism where we all wear solid colors. I don’t think this is really that easy and I believe a large part of the FRAN margin story might be due to favorable terms from related party vendors.
FRAN says that they purchase from “hundreds of domestic vendors”, but 19% of purchases in the last fiscal year were from two suppliers, both of which who were related parties.
So, in a sea of hundreds of vendors that FRAN can do business with, 19% of purchases last year came from two parties that are original founders, the brother and sister of an original founder, and the brother-in-law of an original founder. To FRAN’s credit, they are very clear in highlighting the related party transactions in public filings and have even discussed them in conference calls:
“Again, it's a little bit -- I don't know the right way to put it, but it does keep coming up. And it is a little bit in my opinion, a little bit incredulous, that we keep getting this question concerning the related parties. But as we have disclosed from the very beginning, we do have two vendors that are related parties, as they are defined. But as we have also disclosed, we treat those vendors as independent third parties. We negotiate each transaction with them on market terms, treat them at arm's length, and make sure that we are conducting that in the most upright fashion. Those relationships and the procedures around those relationships are reviewed by our audit committee, and are approved by our audit committee. There’s nothing to it, more than that. We purchase from them because they have consistently provided us with trend-right quality merchandise, and they deliver on time. And that is the reason. We have other vendors that move up in the pecking order and down. But these vendors continue to deliver a good quality merchandise, that's trend right, that has good sell-through, and delivers good margins. So I will continue to answer that question the same way that I have from day one. And hopefully, one day, it will, it will fade into the background.” – John De Merritt – Q2 2012 Conference Call – 06/07/12
I’d point out, though, that simply making us aware of related party transactions doesn’t exactly explain why they are necessary. In the case of KJK, if KJK has only one customer, wouldn’t FRAN be better off just purchasing KJK? From the 10-K: “Although KJK Trading assists us in the design of apparel items, KJK Trading does not act as our broker or agent in the sourcing of our merchandise. We select merchandise for purchase from KJK Trading after being presented with a variety of new styles identified by KJK Trading.” It is unclear from the description that KJK is even a vendor in the traditional sense. They sound like the definition of a middle man. Why does FRAN need a middle man here and not with the other hundreds of vendors they work with? If they paid Mr. Gu his profit margin or even a slight premium FRAN is better off and so is Mr. Gu. Perhaps one reason why FRAN purchases from related party vendors is because the margins on those purchases are higher. Here is the disclosure from prior years (not perfect because inventory is moving slightly, but it is close enough):
Note that as the percentage purchased from related parties fell 4% in 2012, merchandise margins fell 100bps. To illustrate how this might work, see below. I estimate that true merchandise margins for FRAN should be anywhere from 55% to 66% (the high end assumes no benefit from related parties) based on the competitors and factoring in FRAN’s business mix. In order for FRAN’s merchandise margins to be this high under reasonable third-party margins, it implies that merchandise margins from related parties ranged from 77% to 83%, which is obviously much higher than any other retailer.
Why might the related parties be giving FRAN such a good deal? While I don’t know for sure, given that all of the related parties are FRAN shareholders, it seems like giving FRAN a 20% better margin on purchases of ~$14mm per year is more than offset by FRAN’s stock price appreciation as they continue to post industry leading margins and profits. In terms of a catalyst for how this ends, recently, both John De Merritt (the founder and CEO) and Kyong Gill (the Chairperson that is the link to all the related parties) have resigned and left the Company. They can now sell stock without reporting stock sales on a Form 4. One theory is that they can now liquidate their holdings, and the related party transactions will ultimately normalize to true “market” margins as there is no longer a stock incentive for giving FRAN a deal.
Food for Thought
I want to stress that I do not know for sure that FRAN is doing something shady with respect to related party transactions. They are very open about the existence of these related party transactions and the question has been asked before. For that reason, I think it is important that one take a fundamental view on the Company’s growth prospects and its valuation. But, I do think there are enough strange things going on here to raise suspicion.
The following article is referenced by Jim Chanos in “The Alpha Masters” and is a good read: http://www.newyorker.com/reporting/2007/01/08/070108fa_fact?currentPage=all.
The point I think he’s trying to make is that you can approach a short as if it’s a puzzle or a mystery. In a puzzle you gather all the information available and solve the puzzle. But, in a mystery, you can start by acknowledging that you don’t have all the information and then gather clues that can guide you in figuring out what is likely happening. Chanos also refers to both Tyco and Enron and that a CEO leaving when it doesn’t totally make sense precipitates the implosion of the Company. In the case of Enron, the article points out that related party transactions in that case were disclosed, the Company discussed them with those that were interested and Enron was really only “going over the edge, just a little bit.” But, what stood out was that the profitability was artificial to begin with. While I do not know for sure, FRAN’s margins look suspiciously high and going over the line just a little bit here could be boosting profitability materially. I think each of the factors in isolation probably doesn’t raise too many issues, but the multiple data points taken together seem to suggest something misleading could be going on.
As I stated from the beginning, I think it is important that the related party piece of this thesis is a “free” (or at least a cheap) option. The following operating and valuation scenarios show why I believe that is the case. Despite my view that FRAN cannot grow to 900 stores successfully, I have assumed they continue to grow at 75 stores per year for the next 4 years and I continue to grow comps by 10% for the next four years in all scenarios. I also have assumed 100% annual growth for the Company’s online business, which in FY 2012 was only 1.4% of total sales.
Key assumptions: No advertising spend and merchandising margins are equal to the past few years (i.e., nothing going on with related party transactions.
Key assumptions: Advertising steps up from 0% in FY 2013 to 1% by FY 2015. Normal merchandise margins are 60% and related party margins reset from 78.6% to 60% over a three year period.
Key assumptions: Advertising steps up from 0% in FY 2013 to 2% by FY 2015. Normal merchandise margins are 55% and related party margins reset from 82.8% to 55% over a three year period.
Comparing these results to current FRAN consensus expectations below makes it obvious that scenarios two and three will not be good for the stock. In those cases, I believe FRAN would trade at a more reasonable level and at a slight premium to competitors at roughly 13x EBITDA. If FRAN is unable to grow at those rates, I would expect FRAN to trade in line with other mature retailers at 7x EBITDA, sending the stock materially lower to a price below $10/share. Even in those cases my projections assume FRAN continues to grow stores and comps faster than anybody in the industry. If the store growth proves overly optimistic, this will get ugly for the stock fast. In scenario one, if FRAN traded at 18x LTM EBITDA in 2015, it should trade at ~$35 today. Even in this rosy scenario, the numbers are not materially better than current consensus for 2014, implying much is already priced into FRAN’s stock.
DISCLAIMER: The author of this posting and related persons or entities ("Author") currently holds a short position in this security. The Author makes no representation that it will continue to hold positions in the securities of the issuer. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform Value Investors Club, the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are the only the opinion of the Author. The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note.