Small Cap Report (13 Mar) - FCCN, CLL

13th Mar '13 by Paul Scott

29 comments 27989 reads

Pre 8 a.m. comments

Good morning! I've been busy reading & interpreting the preliminary results for the year ended 31 Jan 2013 from French Connection (LON:FCCN), a share which I personally hold. It's a special situation in that the fashion retailer & wholesaler has been trading poorly for about 18 months, and lousy results were expected (with a loss of £7.5m being flagged in the most recent trading statement).

However, there is no new bad news in the results, with the underlying loss before tax being £7.2m. I cannot find any figures on current trading, but they do say (with my bolding added below);

After a difficult trading year, I am pleased that many of the initiatives we have taken in order to provide a new impetus to sales growth are beginning to show interesting results. While it is still early days, we see some good progress, and I am pleased there is some momentum in the business ...

... Although it is very early days in the new year, we have seen a better performance in UK retail, and we expect this to build as the year progresses.

Also, the all-important cash pile is largely intact, with good control over working capital meaning that the catastrophic fall in net cash which bears were predicting has not happened. They ended the year with £28.5m in net cash (compared with £34.2m last year), and the minimum cash position during the year was £10.6m.

Therefore crucially FCCN still has time to turn itself around, which is the fundamental rationale behind my holding the stock - i.e. I don't know whether management will be able to turn it around or not, but due to the very strong balance sheet, they've got time to attempt a turnaround. Bear in mind that at 25p the market cap is only £24m, so it's trading below its own net cash.

Taking into account working capital overall, FCCN has £93.8m in current assets, and £43.8m in total liabilities, so it has net working capital of £50m, or double the market cap! Remember this measure ignores all fixed assets completely, it's just the net working capital - i.e. items which turn into cash within 12 months at most.

The three year chart above for…

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Paul Scott

13th Mar '13

Ed,

Personally I prefer all links to open in a new tab, as otherwise it's too easy to get lost & forget the original thread that took you there, by the time you've clicked on a few things!

Most websites work that way I find, so it's becoming the norm, to have a new tab opened for anything you click on. My preference would therefore be for Stockopedia to follow suit.

Cheers, Paul.

c1d

I think I know why FCCN doesn't have a big onerous lease provision in spite of big losses in the UK/Europe retail business. I think that under accounting rules, provision can only be made for leases of empty shops rather than loss-making shops because otherwise businesses would effectively be able to provide for future operating losses which is not allowed as it would allow a very flattering view of trading to be reported in future years results.

I also don't see the point of the proposed changes to accounting rules regarding leases as they will require businesses to track and crunch numbers for potentially lots of different lease agreements with
varying terms in order to prepare their accounts which will have to include a liability and a corresponding fixed asset (being the right to use the lease). Given that the result of all this work is to gross up assets and liabilities with little overall impact on net assets what is the point! It will result in increased costs (especially for retailers such as FCCN which have lots of individual leases) which
is the last thing businesses need in the current climate.

I don't see how it will help readers of accounts especially given that if anyone wants to make adjustments to treat leases as a liability there is already lots of information in the operating lease commitments note and elsewhere to help them make their adjustments. That's my rant about
proposed changes to lease accounting over! (which is maybe only of any interest to any accountants and deeply boring to everyone else reading this post!!)

I look forward to reading your future commentaries - please keep up the great work.

Funnymoney

Edward,

We need a poll on this, but I would say definitely yes - it is a lot easier to jump around tabs than to refresh a page, especially if your connection is not that fast.

Regards

SevenPillars

You should be able to get pages to open in a new tab if you click on the mouse wheel. Hover the cursor over the link as normal and then click on the mouse/scroll wheel, the link should then open in a new tab. Works this way for me in Firefox and Chrome, should be the same for all browsers. I do it this way on those sites where links for whatever reason do open on the same page.

Hi c1d,

I think you've hit the nail on the head when you said this:

I think I know why FCCN doesn't have a big onerous lease provision in spite of big losses in the UK/Europe retail business. I think that under accounting rules, provision can only be made for leases of empty shops rather than loss-making shops because otherwise businesses would effectively be able to provide for future operating losses which is not allowed as it would allow a very flattering view of trading to be reported in future years results.

I'm a bit rusty on accounting rules, but what you've said makes complete sense, and I think you're right. I will ask FCCN about this when hopefully the FD calls me back later, although I can understand them being busy today.

Regards, Paul.

m8eyboy

The shops FCCN trades from are assets. The obligation to pay for them is a liability. Because of current lease accounting neither appear on the balance sheet. That is surely wrong.

If the company had borrowed money to buy the shops we would count the whole debt as a liability, not just the cumulative losses that might result from trading unprofitability.

In my view leases are just another way of financing the asset - a shop, and as such they should be treated much like debt.

Unfortunately that's very difficult to do because companies don't tell us much about their leases (I wonder why?!).

Hi m8eyboy,

You said;

The shops FCCN trades from are assets. The obligation to pay for them is a liability. Because of current lease accounting neither appear on the balance sheet. That is surely wrong.

I don't see it that way. The value of the asset will actually go up & down, and that is entirely the business of the freeholders. The value (or historic cost) of the property is of no consequence whatsoever to the retailer, he has just signed a contract to have the use of that asset for a certain period of time, at (usually) a fixed rent.

So as long as the retailer accounts for the rent paid in each year's P&L, then I don't see the need for any balance sheet disclosures at all. Creating an enormous fictitious asset, and an equal but opposite enormous fictitious liability does not aid my understanding of the accounts at all.

The asset is actually owned by the freeholder, who should account for it as an asset in his own books only, in my view.

A retailer owning the freehold of their own shop is a completely different scenario - they own that asset, and benefit from the long-term rise in value of the freehold, so it is only right that they put it on their balance sheet.

If the rules need changing at all, it's that retailers who have loss-making shops should be forced into making a disclosure about the number of loss-making shops they own, and what it would cost to exit from each lease, although they wouldn't like being forced to disclose that information.

Retailers will tell you that it would be costly to find out that information, but that's not true - in reality the CEO & FD will have pretty much all the figures on problem shop leases in their heads, as they will spend quite a bit of their time trying to negotiate exits from onerous leases, especially at the moment.

Just in my opinion, I accept that there are different interpretations of the facts on this issue.

Operationally though, the only figures that matter to a retailer, concerning his individual leases, is which shops are loss-making, and how much will it cost to get out of the lease (i.e. surrender or assign it). So perhaps accounting standards should focus in on those key issues (which also are the most important facts for investors to understand, re potential liabilities).

Cheers, Paul.

Boros10

One benefit of "grossing up the assets and liabilities" under the proposed accounting changes to operating leases is you end up with more meaningful return on capital/assets ratios. Retailers look like really efficient users of capital until you see the scale of their ongoing obligations. They are highly operationally geared animals.

True, it is only when things go badly wrong do these ongoing lease obligations become onerous. Which explains why so many retailers have gone to the wall. Once a store starts losing sales the operational gearing kicks in to the downside and it is hard to survive. Next plc, Apple and others, on the otherhand, show how this operational gearing can work to the upside to the benefit of shareholders.

Sorry, I was imprecise. The right to use the shop is an asset. The cost of using it is a liability. I'm not suggesting including the full value of the property on the balance sheet. Just the lease obligation for the minimum length of the lease. Otherwise as Boros10 below says return on capital and gearing figures are pretty meaningless.

Hi m8eyboy,

Yes, I see what you mean on the current arrangements making ROCE figures meaningless, but grossing up the assets and liabilities will also deliver pretty meaningless numbers too. For example, retailers will try to get shorter leases, so that a 5-year lease will show a smaller liability than a 15-year lease. However, that could be detrimental to shareholder value if it meant the loss of a profitable shop because the landlord got a better offer on lease renewal from someone else.

The key point to me is that the leases are NOT fixed liabilities. They are tradeable assets. So retailers frequently assign existing leases to new tenants when they want to relocate to say a larger shop in the same town. It's only in a downturn, with a very heavy rent, that you end up locked into a shop lease which you cannot get out of (and even then, you could get out of it, it's just that it would cost a fortune, maybe 2-3 years rent incentive to persuade anyone else to take on the rent).

Which brings me on to another area where retailers actually have large & completely undisclosed rent liabilities - namely leases that they have assigned to another retailer, which bounce back on them when the other retailer goes bust. This was one of the things that killed JJB Sports - they found that lots of shops which they had exited suddenly reverted to them, when the new tenant went bust.

So perhaps disclosures should also be made by retailers for the number of shops & rents which they could potentially become liable for again, if the new tenant that they assigned the lease to subsequently goes bust?

My general feeling is that additional disclosures would be helpful in the notes to the annual report, but that grossing up assets & liabilities on the balance sheet will I think make the figures nonsensical. Or everyone reading the accounts will just reverse them back out again!

Going back to FCCN, as an investor, all I want to know is - how many loss-making shops do they have, and how much will it cost in total to exit from those particular leases? I'm pretty sure the fixtures & fittings already have to be written off in loss-making shops, as I recall having a battle with the auditors about that in the late '90s, and being amazed at how easy it was to persuade them that loss-making shops would recover into profit & hence didn't need to have their fixtures & fittings written off.

It is a minefield, and as Boros10 correctly says, these things only become a problem in a downturn, when you suddenly find that there are large closure costs involved in getting out of leases where the contracted rent is well above the latest (lower) market rent for that area. Hence the attractiveness of pre-pack Administrations - all the problem shops can just be ditched in one fell swoop, and management walk away with the profitable shops only in a Newco that they bought for almost nothing. Very unfair to existing retailers, who soldier on with many loss-making shops, whilst their less successful competitors do a pre-pack and instantly become more competitive. But that's a separate issue.

Cheers, Paul.

marben100

But surely the problem with that accounting treatment is that whilst the value of the liability is easy to measure, the value of the "asset" is hard to determine? Very different in a freehold situation, where there is a market value for the asset.

Not really sure of the best way forward on this. Boros10 makes a good point about the distorting effect of not considering the capital cost of the premises when measuring ROC.

Miserly Investor

Interesting discussion on onerous leases.

In my view FCCN's accounting policy disclosures surrounding this are very poor. Note for example in HOME's accounting policies it states:

"Provisions are made for onerous lease contracts for stores that have closed or where a decision to close has been announced, and for those stores where the projected future trading income is insufficient to cover the lower of exit cost or value-in-use."

Last year end HOME had an onerous lease provision of £153m and you can see from the above that their policy isn't just in respect of closed stores. Whilst there is a restriction under IAS in terms of not providing for future operating losses, onerous leases are treated differently largely because the losses arise from a prior legal obligation, namely the lease contract. Note however that the provision should be the present value of the "unavoidable lease costs", net of inflows, and the unavoidable costs should be the minimum taking into account options such as lease breaks or surrender premiums; therefore not necessarily the remaining rental obligations under the lease.

The other point I would make is that prior to an onerous lease being provided for, an impairment provision would be recognised against the store's fixed assets. This appears to be fairly modest in FCCN's figures also: from a quick look something like £0.6m over the last 3 years.

Given that impairments and onerous lease provisions are rather subjectively based upon directors' forecasts this is certainly an area subject to significant judgements.

Hi Paul,

In a sense a property funded by a mortgage is a tradeable asset. You can sell the property and repay the mortgage. OK, you might lose money. But you might if you trade a lease.

The point about leases only being onerous in a downturn is true. But the same could be said about debt! This is why defensive stocks can carry higher levels of debt and cyclicals can't, and it is important not to get muddled up between them. Retailers are often cyclical, so the hidden debt masquerading as leases is very important especially as not accounting for the leases make them look more profitable than they really are, and therefore more defensive.

I had a go at modelling the impact of leases on return on capital. The results convinced me to continue accounting for them: http://www.iii.co.uk/news-opinion/richard-beddard/share-sleuths-notepad-finding-hidden-debt

I do accept that bringing leases on to the balance sheet will encourage companies to find ways around the new rules, like using more expensive short-term leases. I just don't think that's a reason not to do it. Some companies will always look for ways of hiding financial obligations but the fewer ways we give them to do it better. After finance leases (where ownership transfers to the leasee at the end of the lease term) were brought on to the balance sheet, the use of operating leases exploded. Few would argue we should roll back those rules though. Better to roll forward...

Hi Marben. The book value of the lease asset is the same as the value of the liability. A lease is just a contract over a period of time. Its value is the cumulative rent. I've just posted this link in response to Paul, but this is my best attempt at an explanation: http://www.iii.co.uk/news-opinion/richard-beddard/share-sleuths-notepad-finding-hidden-debt

timpernel

14th Mar '13

Very interesting debate - thank you. As Paul says, the absence of information on loss-making stores creates a significant gap in understanding the results. I wonder whether it is a case of a few bad apples spoiling the barrel or whether in actual fact there are only a few good apples in the barrel - which might leave FCCN in the unenviable position of having to justify (to their auditors) the absence of onerous lease and asset impairment provisions, rather than recognise an unpalatably large level of such provisions? Although the auditing landscape has changed somewhat since the late '90s, I would agree with Paul that it is by no means impossible to persuade auditors that poor trading performance is temporary rather than permanent - especially if the alternative would effectively mean that the auditors would by implication have to seriously consider a going concern qualification on a business with substantial cash on its balance sheet!

It will be very interesting to see what response Paul gets to his question, but I suspect that the FD may have to dodge giving a straight answer.

FCCN was at a low when the search results for it were at an all time high (DEC 2009). At the moment the reading is 52 for March vs 66 for March 2012. We are now at an approx five year low for on-line search interest.

At the moment this does not look like a turnaround situation.

16th Mar '13

Hi,

timpernel - good points. The FD has not called me back yet, so I shall put in another call to the company next week.

Funnymoney - I've seen those stats on internet searches before, but it doesn't tally with FCCN seeing good growth in eCommerce, see this article:
http://internetretailing.net/2013/03/french-connection-sees-significant-growth-online-as-group-profits-and-sales-fall/

So maybe internet searches are only relevant for new customers, but existing customers know where FCCN's website is already, and probably have it bookmarked, so why would they need to search for it? Just thinking out loud, I don't know enough about the internet to be sure either way.

My view on the leases is that FCCN just has to keep trading, and gradually (over the long term) the problem leases will disappear, as leases expire (typical retail leases are 15 years, so at any point in time most retailers have a fairly even spread of lease expiries between 0-15 years). Also management can assign problem leases if they can find a new tenant on acceptable terms, and who is acceptable to the landlord (who has a right of veto over assigning leases). The problem is that as FCCN is so cash rich, then landlords want to keep it as the tenant, and the landlord doesn't care that FCCN are losing money from the shop.

Losing £16m on turnover of £103m for their UK/Europe retail division is just a totally disastrous performance, and so bad that I suspect most of their shops must be loss-making. So unless things significantly improve, then mgt should probably be thinking in terms of long term winding down the retail side altogether, and just focus on internet, wholesale and licensing.

That said, High Street rents have to come down, and gradually will do, over time. They're just way too high at the moment. Inflation will gradually erode them though. 3-5% compound inflation will over 5 years make quite a dent in a 5-year fixed rent, then zero uplift on rent review, and another 5 years of fixed rent, and you've pretty much fixed the problem in 10 years.
I certainly wouldn't be investing in the shares of landlords of retail units, as it's very difficult to see how they will achieve increased rents in anything other than prime footfall areas.

Cheers, Paul.

22nd Mar '13

I can understand the logic that "maybe internet searches are only relevant for new customers" but let's look at ASOS, which has been "overpriced" for more years than I can remember:

Dec 12 100
Dec 11 87
Dec 10 74
Dec 09 58

JillRivas

13th Jan '15

Great article. Thanks for the info, you made it easy to understand. BTW, if anyone needs to fill out a Residential Lease Agreement, I found a blank form here.

roddy10

I have looked at both FCCN and HOME over the years. I think the comparison is worth making:
(1) In the case of HOME in 2011/12 I felt that a lot of the issues were one offs and actually improved the long term competitive position - eg the closure of Best Buy and Comet led to short term dumping of stock by competitors due to liquidation. Given that electricals / electronics are a significant contribution to the revenue of Argos the short term pain of BB and Comet closing did hurt but longer term Argos was going to be in a better competitive landscape. Secondly on the HomeBase side I thought that the acquisition of Habitat would make a significant contribution. Thirdly the company had identified its weak stores and planned to not renew leases. (There were other issues eg withdrawing from the computer consoles market to avoid being hit by inventory post Christmas etc)
(2) When I look at FCCN I find it difficult to identify a single (or a handful of) one off issue that has been the cause of the poor profitability. One has to be careful to say it is as easy as closing down loss making stores - Argos made the point that even its poor performing stores made a 'trading profit' (however that is defined) and that the cost of closure would be greater than to continue trading. Additionally closing stores reduces overall group volume - and though some customers will stay loyal to the chain the risk is that the fall in trading volume will hit gross margins significantly.
(3) A store chain reducing its store count also often loses its more energetic and enthusiastic staff - who wants to work for a chain that is on the way down.

So what would I look for in a turnaround in FCCN:
(1) Sadly (!) I visited the FCCN store in Westfield with my wife before Christmas. Her view was the designs are not quite there yet and the positioning is confused - what is the target age group? As a result the pricing was not right. Further the available sizes appeared to be limited
(2) So I would be looking for a clearer positioning; with targeted product. Better availability in store. And differentiation.

I thought I would add an addendum - I often wonder if managements ever visit their own or competitors stores. For instance does M&S management ever visit Primark, Zara, H&M or Next? The reason I ask is that the M&S estate is one of the most variable I have seen - even in the same store some parts can be attractive and other bits downright dour and dusty. I have not visited enough FCCN stores to make a more general comment on their estate however! But from what we did visit I would observe that there was also not a consistent 'brand value' eg a discount rail stuck in the middle of the floor - reduces the 'perceived' value of your surrounding full price products.

Secondly a point of clarification - positioning is different from what your actual customer base really is. For instance a lot of perfumes are bought by the middle aged or older customer but the 'positioning' or 'appeal' is based on youth. Similarly someone recently commented elsewhere that Superdry tops are bought by 15 yr olds and 45 yr olds - but the 'positioning' of SuperDry will be aimed at the 15 -25 y.o mkt.

Other views appreciated

Small Cap Report (13 Mar) - FCCN, CLL

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Paul Scott

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