Hi,Thought I would kill 2 birds with 1 stone, since French Connection (FCCN) is both my unique pick for the Nicky Fraser Share Competition entry this year, and also Dave kindly arranged an investor meeting & presentation with the management of the company yesterday, at his new Mello Morning After function kindly hosted by FinnCap, which was a great success & most useful, many thanks!As usual, we should start with the market cap, since everything else is meaningless until put in context of what the company is valued at:40p/share * 96m shares in issue = £38mLet me state at the outset, that I think the mkt cap is ludicrously low, and that IMO this is a great time to buy the shares, since they are pretty much at a 5-year low, and barely above the company's own net cash, and well below the value of the company's own working capital (and there are no long term creditors to take off, other than £0.9m deferred tax).It's pretty much the perfect share for me - easy to understand business, bullet-proof Balance Sheet stuffed with net cash, rock bottom valuation, profitable business, shares bombed out because company has under-performed, but potentially big upside in for free.We saw only last year how the first signs of a trading recovery saw the share shoot up to peak at around 140p. Thankfully I sold, as it seemed to me the price had got ahead of the recovery, so that was a cracking profit banked. I went back in at 60p, and have been buying more all the way down to 40p. Certainly I can see a relatively easy opportunity to double or triple your money here, with little risk, at some point in the next year or two. But that's only my opinion, so please DYOR as usual!I'll follow the format of the slides presented to us at yesterday's meeting (interspersed with my comments below), by Neil Williams (COO), and Roy Naismith (FD), both old hands, having been with the company for 17 and 11 years respectively. The founder, CEO & Chairman, Stephen Marks, was not at the meeting, but more on him later.(also, apologies in advance for any typos, I spilled some cider on my laptop a while back, hence some of the keys stick!)Outline of the business* Established over 40 years* Upper-middle priced fashion (75% ladieswear, 25% menswear)* FC product is sold globally* Not just a retailer - more product is sold through third parties (other retailers, and franchisees), which nicely reduces risk* Lucrative income from brand licensing (£5.6m income, and growing, which is pretty much pure profit)* transactional website is here: http://www.frenchconnection.comStephen Marks (the founder) takes an active, full-time role in the business, and is described as a young 65 (plays sport, etc), not showing any signs of slowing down or wanting to exit. He is focused on product, and is "editor in chief", i.e. selects & amends product proposals from in-house design team. Also focused on brand, advertising, marketing, etc. So very much a product & design man by the sounds of it.Entrepreneurial business, with a flat management structure.* 335 French Connection branded stores worldwide (over 40 countries), of which 138 are company operated (the balance being franchisees)* Over 1000 stockists supplied through wholesale* e-commerce sales are profitable, and operated in 4 continents, multiple languagesWe briefly discussed the over-exposure of the "FCUK" branding & slogan T-shirts about 10-15 years ago, which was hugely profitable for a time (profits rose to ballpark £40-50m p.a. at the time, before collapsing as the trend passed). This is now only used selectively on casual menswear.Also interestingly, FCUK is a novelty in some emerging markets, whilst being passe in the UK.I'll skip over the slide which dealt with the breakdown of sales, as you can get this from the Annual Report.What struck me is that some investors have said to me that they see the FC brand as being old hat, had it's day, etc. But they are basing this on the "FCUK" slogan T-shirts from the 1990s, which were horribly over-exposed, and did become naff afterwards. However, the evidence from licensing income of £5.6m (and growing) is that the brand has considerable attractions for the public. For example, lucrative deals are in place with Boots & Specsavers (10,000 FC branded glasses sold per WEEK!), amongst others, and this is what excites me about this share. It should not be seen as a retailer, it's actually a brand. An internationally recognised & respected brand, so it's not difficult to see that commanding a valuation of say £100-200m if the brand was really maximised. If it became really cool again, then you could be looking at a multiple of that - just look at what Superdry, Burberry, Mulberry have achieved. British brands that hit a sweet spot with fashion-conscious customers globally can become seriously successful, so there is potential here, but my feeling is that management at FC are not even scratching the surface of what could be achieved with this brand if they made it hot again. Quite how you do that, is easier said than done. But it has to be driven by product, which needs to be exceptional, rather than just good. And celebrities need to be seen wearing FC product, which does seem to be happening a bit - e.g. Pippa Middleton has been "Papped" wearing FC designs, and if they can snowball that kind of indirect celebrity endorsement (i.e. celebs actually wearing the product because it's cool, rather than being paid to promote the product).Other BrandsFC also owns 75% of "Toast", which has 9 stores, and is also sold in a few John Lewis stores. Could be interesting if it takes off? www.toast.co.ukYMC - another brand, with 2 stores & website http://www.youmustcreate.com/Great Plains - is said to be strong in wholesale.http://www.greatplains.co.uk/index.aspx?mscsmigrated=trueWhy have additional brands, I hear you ask? It makes sense to me, since it's very easy to bolt on additional small brands onto an existing infrastructure - everything is already in place, e.g. distribution, accounts, area managers, etc, we did this at Pilot too, and it's very easy to absorb a few more stores with different branding. Hence shared costs, etc. And a cheap way to find out if a new brand could become a big winner of tomorrow. If not, just close it down. As long as they don't actually lose money, then it's a good opportunity. We forgot to ask whether they are profitable or not.Operating SegmentsThis was the most interesting bit of the meeting, where we got into the various parts of FCCN, and it became clear that FC is essentially a reasonably successful Wholesale business, with a rubbish retail business attached to it!Consider the following figures for year to Jan 2011 (the figures for 2012 should be pretty similar, slightly lower overall);UK Retail: Turnover £111m, Loss of £1.6mUK Wholesale: Turnover £36m, Profit of £5.8mUK Licensing: Turnover/Profit of £6.9mHence in the UK, you have a profit of £12.7m generated by Wholesale & Licensing, reduced to £11.1m profit once the Retail losses are deducted, then there is £4.2m in common overheads, so that drops out at an over profit of £6.9m which in my view is hardly exciting, but given the pretty dreadful economic situation it's actually not bad.I questioned them closely on why the Retail side isn't working, but Wholesale is. The retail figures say to me that the product is not good enough. But Wholesale says that the product is good, and Licensing says that the brand is good. Confusing!Management said their view is that the Retail side does not achieve high enough sales densities - i.e. they need to sell more per sq.ft. of space. As such, they are looking at each store, but insist there are only a few that actually lose money, while most are around breakeven. And remember they only have about 70 UK stores, so this is not a big problem at all. We discussed problem stores for a while, and as with all retailers, once you've signed the lease, that's it, you're stuck with the shop, unless you can assign the lease to another retailer. But with all the problems out there, few are expanding, and FC's loss-making shops are just bad shops in bad centres, where there is no demand from other retailers at the prevailing rents (Lakeside, Thurrock was given as an example).My view is that there needs to be a step change downwards in rents on the High Street, or we will see carnage, with boarded up shops left, right & centre. But landlords can't reduce the rents, as they support valuations which affect their own mortgages on the properties. So a very difficult time for the sector as a whole, and my feeling is that FC are doing what they can to manage a containable problem.The bottom line is this. The product is not as good as they think it is, and in order to compete on the High Street, the product has to improve significantly, in my opinion. Other people (e.g. Next, SuperDry) have proven that retail can still work, you just have to get the product right! And what works in the relatively cheap floorspace of a Department Store, or independent retailer in a small market town (i.e. FC's wholesale customers) will not work on the sky-high rents of the High Street and glitzy shopping centres. So FC need to up their game! I think they realise this, and didn't get any pushback from mgt when I made these points. But product is down to Mr Marks, and I do wonder whether he should be bringing in new talent into the business on the product side, and maybe taking a less prominent role himself? You have to keep fashion fresh & exciting, and I don't know whether that is possible after 40 years in the same job?Current trading - obviously they couldn't give us any details on that, as the year-end is imminent, 31 January. But was is interesting, is that many people (including myself) expected another profits warning after Xmas, and it hasn't happened. Mgt made it clear that if they had needed to warn on profits, they would have done, so that implies they are broadly on track to meet brokers consensus of about 5.5p EPS for this year ending 31 Jan 2012.That puts the shares on a PER of less than 8, and we haven't even considered the cash pile, which at around £30m makes up virtually the whole mkt cap! So on an EV basis this could be the cheapest stock on the market, as I reckon you're on a cash-adjusted PER of about 2!Although PER is not that reliable when you're close to breakeven, as this is.Brokers consensus is 1.75p divi, but that looks warm to me. The Interim divi was up 20%, so reckon the total divi might be between 1p and 1.5p for the year. Still gives a useful if unspectacular yield whilst we're waiting for the big capital gain that is hopefully in the pipeline!Other points, in no particular order;* Staff turnover is low - whilst good, I do get the feeling that FC needs a good shake-up. It seems as if everyone has been in their jobs a very long time, and with a huge cash pile, everyone is comfortable. But that's only a hunch. Having tons of cash creates opportunities in buying (rag trade suppliers are always strapped for cash, so you can negotiate great discounts if you can pay cash on delivery, which FC mgt are fully aware of!)* Bad debts from wholesales - very tightly controlled, and fragmented customer base, so seems under control.* Mgt accept that their operating margin should be 5-10%, but there didn't seem any decisive plan to make it happen. I think they're broadly on the right lines with their aims to constantly improve product, operational standards, visual merchandising, store appearance, etc. But to me there's something missing here. To really hit the big time again, in my view FC needs a big bazooka - and that can only come from exceptionally good product. If you get the product 100% right, then sales will jump 20-30%, and gross margins will also soar. They have a bought-in margin of mid-70's%, and a retail margin of 60%. That means that a helluva lot of stock is sold in the clearance sales, that should have been sold at full price. What does that tell us? Well, it means that they are making a lot of mistakes with product - putting out a lot of lines which are not attractive enough at the asking price for customers to buy them. Hot designs should fly off the rails at full price, but clearly not enough of that is happening here.Hence if they improve the product, you will not only see sales rise, but you will also see gross margins rise from 60% to 65% or more potentially. Bake all that in, and there is potential for the Retail side of the business to become very profitable, but at the moment it's not happening, and I blame that largely on inadequate product. I visited their Oxford Street store in Xmas Sale week, and was very underwhelmed with the Winter ranges - which looks boring, and over-priced, in my opinion. Mgt did indicate that both the mild weather, and perhaps some shortcomings in the Winter range had caused the profits warning in November. http://www.investegate.co.uk/Article.aspx?id=201111170700182...Although important to note that profits warning does say that Wholesale & international are doing well.North America is a similar picture - Retail is poor, with a £0.6m loss on £23.2m turnover, whilst Wholesale is small but excellent, £4.2m profit on £19.5m turnover.However, it's clearly very top-heavy, since common overheads of a whopping £3.6m consumes all the profit, leaving N.America at breakeven. So a fail there.Rest of the World fares better, with £1.5m profit on £15.4m turnover, and a very nice £2.0m licensing profit on top, so £3.5m profit there - the best profit from the smallest part of the business!This is also the most interesting growth area, with 197 franchised stores already operating, and 25 new stores planned for China, 8 for Russia, India, etc. Hence International is likely to become increasingly important to FC. We asked whether there is confusion over the name, but no, everyone understands it's a British brand.Directors don't own any shares, other than Stephen Marks, who owns too many! (42% of the company). This was questioned by us, with mgt seeming rather indifferent about it, just saying "we've got Share Options". But it does make you wonder why they are not filling their boots with shares, given the current valuation. Doesn't fill you with confidence, but there we go.They don't have any share buybacks planned, and intend sitting on the cash pile, saying that it has given them safety to ride out downturns over the years. So they seem a very cautious team, intent on hoarding the cash (which is better than blowing it on some crazy acquisition, as many companies tend to!).SummaryI think the valuation at FCCN is tremendously exciting. As soon as there's a sniff of a trading recovery, then the shares could easily double or triple again, as indeed they did last year, before falling back again.In the meantime, mgt seem fairly adept at holding together a less than optimum performance, and despite all the problems affecting the sector, FCCN has remained profitable this year (no mean feat considering LFL sales were down 9.5% in the autumn, which would have pushed many retailers into heavy losses).They are cushioned by the excellent Licensing income, and the Wholesale business is sound, but Retail is struggling, although probably only modestly loss-making in the current year. Hence their business model is far lower risk than most retailers, a point which I don't think the Stock Market has grasped, meaning more free upside.Once retail is turned around, then there's potentially big upside on these shares. It's a lovely, low risk, high reward situation at this valuation, in my opinion. It amazed me that from what I could tell, nobody else at the meeting seemed to see the opportunity I see here, but investor mood seems set in stone of downturn, EZ crisis, etc. But if you look beyond all that, there are some great bargains out there. I see that as an opportunity. Loads of small caps about that could double or more once the market begins pricing in growth again, instead of pricing in further downside, and I feel that shift is near, hence am feeling optimistic about 2012 paradoxically. Let's just hope Merkel finally pulls her finger out & cranks up the ECB printing presses!Best wishes for 2012 to everyone, may it be happy & healthy for you & yours, and even better if we manage to make some money too!Regards, Paul.
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