French Connection's (FCCN:47.8p) highly profitable wholesale operation and licensing income are edging the clothing retailer ever closer to profitability even though the share price was marked down by 6 per cent on the day of its interim results.
The share price move is more a reflection of liquidity in the tightly held shares – the four largest shareholders control 81 per cent of the issued share capital, including the 41.7 per cent stake held by chief executive, chairman and founder Stephen Marks. Indeed, only around £150,000-worth of trades actually went through the market on results day, representing just 0.3 per cent of its £46m market cap.
Far more informative for me is management guidance to expect a return to profit for the full year as the company enters the all important winter months, during which time its retail division makes seasonal profits (in the second half of the previous financial year the retail division made an operating profit of £3m). Furthermore, a healthy order book for the profitable wholesale business suggests that predictions of a long-awaited return to profits has substance.
In the first half to end-July 2018, French Connection’s wholesale revenues rose by almost 9 per cent at constant currency to £30.8m to deliver a 24 per cent increase in divisional operating profit to £4.6m, buoyed by orders from UK retailers with online activities, and by US department stores, especially Bloomingdales and Nordstrom. The profit contribution from wholesale combined with flat licence income of £2.6m offset the slightly larger seasonal loss of £7.2m from French Connection’s perennial lossmaking retail division.
Of course you have to account for £5.2m of central overheads and a £300,000 share of losses from joint ventures, which is why French Connection posted first-half underlying operating losses of £5.5m, albeit that was £400,000 better than the first half last year. Still, given that the wholesale division made £8.4m operating profit in the second half of the 2017-18 financial year, and the retail division reported a seasonal second-half operating profit of £3m in the same period, then with operating expenses kept in check the company should be able to wipe out its first-half shortfall and turn profitable for the full year to end-January 2019.
As has been the case in the past few years, progress is never straightforward at French Connection. In the latest half-year accounts, the £9.7m profit booked on the disposal of a 75 per cent stake in Toast ('Riding earnings momentum', 16 April 2018), a premium lifestyle brand that sells womenswear, accessories and homeware, was matched by a similar sized exceptional loss. The one-off charge included a £0.8m hit from the collapse of House of Fraser, a £2m bad debt provision in relation to French Connection’s Indian licensee, and a £6.4m provision for onerous leases on lossmaking stores the company is looking to exit.
There can be no glossing over how tough retail trading conditions are on the high street: like-for-like sales in the UK declined by 7 per cent in the six-month trading period and a total of eight lossmaking stores will close by January 2018. Encouragingly, though, both the Winter 2018 and Spring 2019 collections have been well received, French Connection has managed to negotiate lower rents with landlords, and unlike other retailers the company is not in financial distress: net funds of £12.8m account for 30 per cent of net asset value of £40.9m on a debt-free balance sheet.
Moreover, cash will build in the second half as French Connection converts stock into cash to provide a hefty buffer to support a turnaround that admittedly has taken far longer than I had envisaged when I first suggested buying the shares, at 45p, in my 2016 Bargain Shares portfolio. However, the company is moving in the right direction, and it’s not going to take much in the way of incremental margin improvement to get profits rising on £135m-worth of annual sales once the business hits profitability.
In the circumstances, I think it’s still worth holding on to your shares if you have been following my advice. Hold.
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