Stephen Marks, French Connection’s chairman and chief executive, has just experienced the most difficult winter season in all his years in business. That’s saying something considering he founded the fashion company in 1972, and rescued it after the recession of 1989.

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Its a cliché but French Connection, or at least FCUK was an iconic fashion brand. It’s sold wholesale internationally and through the company’s own stores and department store concessions in the UK, primarily, the US, and recession-bound Ireland, Span and Portugal. The company also has two stores operated as joint ventures, one in Honk Kong, and one in China. There’s less buzz about French Connection these days, and nearly 10% of sales come from newer brands YMC, TOAST and Great Plains. It licenses its name to ranges of spectacles (sold in Specsavers), toiletries (Boots), watches, fragrances and jewellery.

Bargain / Recovery / Cyclical / Stalwart / Growth

While wholesale, licensing, and international operations are growing at varying speeds and overall it’s making a modest profit, French Connection is losing money retailing in the UK Europe and North America, which accounts for 60% of sales. While costs like leases, are fairly fixed or, like cotton prices, volatile, revenues are falling as customers restrict shopping to sales periods, or find bargains on the Internet. Since French Connection targets the high-end of the middle-market, its vulnerable to cheaper brands during slow-downs.

Expectations

To keep prices and sales up, French Connection has launched an exclusive premium range for women, a range of homewares, and aims to minimise discounting. To keep costs down it’s negotiating lower rents as leases expire, six this year and eight next out of 71 stores in total, and will close unviable stores. Press reports suggest the company may go further, and sell off some of its most expensive leases before they expire. Turning the stores around will, says Marks, take "a number of seasons", which could mean years, and if they require refurbishment that could eat into cash flow.

Threats

competitive position – weak
Though French Connection’s vulnerability to cheaper brands is cyclical, the fading of the FCUK brand and the emergence of the Internet are more intractable dents in its competitive position.

finances – normal
I’m reluctant to say French Connection’s finances are strong, despite the fact it has no debt or defined benefit pension scheme and £34m in cash. Its retail stores are losing money partly because of lease obligations agreed when they were profitable. Those obligations (£218m) are a kind of debt not recorded on the balance sheet. Include them at face value, and French Connection’s tangible assets are almost 80% funded by ‘debt’.

management – strong
Marks has the experience and the incentive to turn the company, his life’s work, around. The value of his shareholding is more than thirty times his salary last year.

valuation – cheap
The shares trade at a 38% discount to tangible book value.

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Verdict

If Investors expect a rapid turnaround, they’re likely to be disappointed. But now Marks has accepted unprofitable stores should be closed, I think he’s doing everything he can to contain costs and design and source attractive fashions, while demonstrating via licensing the brand still has some value and international appeal.

The shares are very cheap, but the core business is misfiring and the lease commitments are a little daunting. Even though I think Marks can make French Connection prosperous again, I’m going to wait for signs the recovery has resumed before adding more shares to the Thrifty 30.

Notes

• French Connection, TOAST, YMC, Great Plains
• Between 1989 and 1991 Stephen Marks lent French Connection £3.5m to help turn it around.
• Performance in year to 31 Jan 2012
• Effect of leases on financial strength and valuation
• Stephen Marks: holding ratio
• More about French Connection
• Blogger Expecting Value charts French Connection’s falling popularity (via Google)
• Poppy Dinsey on French Connection
• The Thrifty 30

Stephen Marks founded French Connection in 1972, rescued it from the recession of 1989 and is currently turning the company around again. The bad news is it needs turning around…

The good news is he has the experience to do it and the value of his shareholding is 32.6 times his annual salary, giving him a very big incentive:

Leases are not only key to interpreting French Connection’s financial position, they affect valuation.

According to the definition French Connection is a net-net, the ultimate bargain, because the balance sheet value of its current assets, those most easily convertible into cash, minus all liabilities is a fraction of the share price. This was Benjamin Graham’s rough proxy for liquidation value. Quite possibly the company could stop trading, sell its assets, repay its liabilities, and still have more than enough money left over to justify investing in the company at the current price.

But that might not be true of a company, like a retailer, with large lease obligations, rent it’s committed to paying for stores. I’m not sure if Graham had to grapple with leases. Their pervasiveness may be a modern development, as companies realise they can exploit the fact that lease obligations, unlike debt, are not recorded on the balance sheet. 

Operating leases are, in the main, long-term obligations, so if we add their value to the balance sheet they become long-term assets, like property plant and equipment, and liabilities, like long-term debt. Since the net-net calculation deducts liabilities from current assets only, the assets don’t count but the liabilities do.

Including leases at face value gives a net current asset value of minus £160m. In other words liabilities exceed current assets by £160m, so there is no net current asset value (minus £79m).

Using Graham’s slightly more refined liquidation value measure, which reduces the value of non-cash current assets to reflect the fact that stock is likely to be sold off cheaply if the company is going out of business but includes heavily discounted values of long-term assets, like the leases, also gives a negative result (minus £79m).

The shares are very cheap. The market value is 38% below the value of tangible book value, but French Connection is not in ultimate bargain territory.

Leases are key to the interpretation of French Connection’s financial position. With no debt and no defined benefit pension scheme it has very few liabilities on its balance sheet. Bring off-balance sheet obligations into the analysis though, and ratios relating to borrowing change alarmingly.

The lease commitments should be discounted to account for the fact that some of them will be paid many years in the future, but its a vague calculation requiring estimation of how long the leases will be paid for (the notes to the accounts only disclose the commitments falling into three bands, less than one year, one to five years and over five years) and how much to discount the payments by.

As I don’t have this information, and the actual obligations could be higher after future rent reviews anyway, I’ve used the total obligation which seems more prudent than reducing it by an arbitrary amount.

If you consider leases, which are non-cancellable, to be a kind of debt, at nearly 80% of tangible assets, French Connection looks heavily indebted.

If you don’t, it’s a financial fortress.

French Connection‘s 2011 results seemed to herald a recovery, but the fashion retailer has suffered a French correction. The good news is it’s still profitable. The bad news is profitability has fallen to meagre levels when investors expected an improvement.

My spreadsheet shows an F_Score of four out of nine, five really because the share issue was minuscule and part of executive remuneration as opposed to say, a fund raising, so it’s is no reflection on the financial strength of the company.

An F_Score of five is the minimum I require to add shares in a company I think is recovering, after all, a recovering company should be getting healthier. Profitability is the single most important factor in judging a company’s financial health, though, and all four failures measure profitability, or the drivers of profitability, profit margins and asset turnover.

Deciding whether to add more French Connection shares to the Thrifty 30 is going to be another borderline decision.

I’ll discuss what’s holding French Connection back (its stores) in upcoming posts on leases and, of course a summary two minute monologue.

Premier Foods’ earnings yield is 15% if you divide earnings by price conventionally,  6% if you divide earnings before interest and tax by enterprise value, a method popularised by Joel Greenblatt, or 7% if you multiply median return on capital by how much you’re paying for the capital, the method I chose when I evaluated the company.

Which is best?

An earnings yield of 15% suggests that investors buying at the current price might expect a return, paid or reinvested in the company of 15%, which makes the shares look cheap (it’s the same as a price earnings ratio of just under 7). A yield of 6% (close to a PE of 17) is much less appealing.

The difference is debt. The basic earnings yield calculation ignores debt. More elaborate measures add it to the price of the company to give enterprise value, the price a buyer might pay for the whole business including the cost of repaying the debt. With no debt to pay, the earnings figure need not be encumbered by interest so the denominator in the Greenblatt earnings yield calculation is EBIT, or earnings before interest and tax.

I don’t think investors should ignore debt in determining the market’s valuation of a company because a company can easily get itself into more debt, and, perhaps with more difficulty, pay it off, which has implications for future earnings, and therefore the current value of the company. The higher the future earnings, the more valuable the company is now.

The basic earnings yield fails to recognise the potential in a company with little debt, and overestimates the potential in heavily indebted ones. Companies with ample resources can invest or return capital to shareholders, probably increasing future earnings. Companies like Premier Foods (which is struggling to pay the interest on its debt), must (literally, at the behest of its bankers) reduce investment to pay off debt, potentially reducing earnings.

If future earnings are likely to be higher than past earnings, the earnings yield, which is based on past earnings will undervalue the company. Likewise, if future earnings are likely to be lower, the earnings yield will overvalue it.

By using a measure like the earnings yield investors are thinking something like: "If earnings in the future are like they were last year, an earnings yield of X% is the return we might expect", but that’s not true if the company will be operating with a different level of debt in future.

Premier Foods will be, so I used Greenblatt’s method of calculating the earnings yield, with a couple of adaptations. The last calculation, which I have inelegantly dubbed the ‘long term post-tax earnings yield’, reincorporates corporation tax to give a truer estimate of the yield shareholders might typically receive. It also uses average returns, rather than relying on a company’s most recent, and possibly anomalous, results.

I’m thinking "If the business had no debt, this is the kind of return I might expect to receive."

It’s unlikely Premier will repay all its debt, most prosperous businesses can sustain some, so my earnings yield is too pessimistic and the truth may well be somewhere between 6% and 15%. The size of that spread, though, is an indicator of how speculative any such calculation would be. Since Premier’s tangible book value is negative, pinning a valuation on the value of its assets instead of its future earnings is also speculative, so I decided the company was too much of a gamble for the Thrifty 30.

Notes:

• How I calculate the earnings yield
• Premier Foods in 2 minutes 11 seconds

New management is dealing with Premier Food’s onerous debt, but they only have a two year window in which to turn the company around or it may no longer be making exceedingly good cakes.

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Premier Foods owns some of Britain’s best known food brands, including ‘power brands’ Mr Kipling, Ambrosia, Sharwood’s, Loyd Grossman, Bisto, OXO, Batchelors and Hovis. It also manufactures non-branded food for retailers.

bargain / recovery / cyclical / stalwart / growth

In the words of its new managers, the company they run is “complex and unfocused“. It was assembled from debt that could not be sustained after the credit crunch and now constrains the company.

Expectations – focus

Premier is focusing on eight power brands responsible for 68% of branded sales, which it believes have greatest scope for development, while reducing costs and selling off some of its lesser brands, including Branston, Hartley’s, Homepride, Bird’s, and Mother’s Pride. It has little choice, disposals are mandated by its lenders, who have prohibited dividends and limited capital expenditure. What money Premier has to invest is going on IT systems, TV advertising, promotions and developing new products like Hovis Farmer’s Loaf and diamond Jubilee Mr Kipling cakes.

Threats

competitive position – weak
The latest annual report, to December 2011, describes a company losing ground because it cannot afford to market its renowned brands while paying the interest on its debts. Its competitive position could, therefore, be improved by reducing its debt.

customer relationships – weak
Last year Tesco retaliated against price rises by temporarily removing Ambrosia, Batchelors, Loyd Grossman, and Sharwood’s products from its shelves and there have been similar disputes in the past. Premier plans to improve relationships with customers by developing joint business plans instead of its earlier and more adversarial approach.

management – promising
Michael Clarke was appointed chief executive in July. He is a former president of Kraft Foods Europe, and before that Coca Cola. Mark Moran, chief financial officer, came from SSL, now part of Reckitt Benckiser in December.

Although they haven’t been running the company long, their time spent with big brands is impressive, their plan is clear, and they’ve completed the refinancing. Moran’s committed to the company, he owns shares worth about £2.6m.

finances – weak
In March, Premier came to new terms with its lenders that last until 2016, with some breathing space built in until 2014. Until then, part of the debt bears no interest and the pension scheme has deferred deficit repayment contributions (normal contributions continue). After 2014 the interest rate goes up too.

Overall the company’s debt, including operating lease commitments and the pension deficit amounts to 126% of tangible assets, which is, frankly, scary.

valuation – speculative
Premier’s net tangible asset value is negative. Factoring the debt into the market value makes puts it on a 7% earnings yield based on its eight year record, which makes it look expensive.

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Verdict – a gamble

The value of the brands are unknowable but the debt load is certain. Instinct tells me Premier is probably undervalued under new management. I like the commitment to sustainability and partnering with customers and, if Premier can sort out its finances, it should become more competitive.

But if the company doesn’t pay off its debts fast enough from increasing cash flows it could go bust.

The shares have risen lately, but I won’t be adding Premier to the Thrifty 30 until business performance improves. It’s current F_Score of just two (out of nine), indicates it’s still in trouble.

Notes

• Premier Foods website
• The Grocer: Delistings by Tesco push Premier into profit alert
• My template for a recovering company
• Premier Foods’ history, including acquisitions and disposals
• Mark Moran joins in December: “There’s no silver bullet“
• More about Premier Foods
• My Premier Foods worksheet (2 pages)
• How I calculate the earnings yield
• The Thrifty 30

I’ve updated the Thrifty 30 performance table and as usual have nothing to say about the portfolio’s performance in terms of share price movements. But I’m still thinking hard about my my own performance.

Recently I’ve changed my stock picking process, the efficiency of which I will measure by the number of two minute monologues I publish every month. I’m hoping to go from a couple a month to a couple a week by streamlining analysis and various other activities.

The idea is to turn over more rocks, and find more of whatever it is people look for under them: undervalued companies to transpose the analogy to investing.

It’s not an original idea. Like the two minute monologues, I nicked it from Peter Lynch.

The relentless drive for efficiency is as important in investing as it is in business, because investing is competitive and the spoils go to those with most insight. For some time, I’ve felt inefficient both in deciding which rocks to turn over, and in scraping away at what I find beneath them.

The two minute monologue enforces concision. It requires a description of the business, my expectations for it, and the main threats in at least four categories: competition, management, finances, and valuation.  So that’s twenty seconds per section, assuming the basic six sections.

Filling in the monologue as I research keeps my eye on the overall picture. If the company is shrinking dramatically, say its paying the price of  over-expansion, it’s past earnings and competitive position may not matter much to me. I’ll concentrate on the management, finances and valuation (relative to hard assets). Instead of filling a giant spreadsheet examining its ten year record across all categories, I’ll just do the sums I think necessary.

Then there’s finding the companies. Now my old workhorse Sharelockholmes has been joined by the even more versatile and rather beautiful Stockopedia in my armoury, I could get very clever with screening. Screeners like these let you turn over the whole market in a second.

But that’s not the way I’m going.  Despite the vast array of statistics available to investors in these programs they mostly help find companies that are cheap relative to fundamental factors, or that are doing well in terms of price performance, or that are highly profitable, or unindebted. Things that can measured using data in the accounts.

No matter how I tweak my screens, the same old companies come up. Either I’ve already added them to the Thrifty 30, or I’ve rejected them because of things that aren’t so easily measured (pension deficits, operating leases, broken business models, you know the list!)

Relentlessly perusing old lists is not efficient. It can be depressing and lead to a kind of myopic scraping at infertile ground in the hope that you will find a seed that might germinate.

Instead I’m throwing the net wide open, my only criteria being that a company has been listed six years and has been more profitable than unprofitable in that time.

I expect to find value in unexpected places which can’t be captured easily in numerical terms, in the company’s competitive position, it’s management or its culture. I also expect to find companies I’d like to invest in, but not at the current price.

Should the price of a company like Churchill China fall, and the business remain attractive, I’ll be ready. Should the uncertainty facing PV Crystalox Solar diminish, and the price remain attractive I’ll be ready too.

That seems efficient.

So, how am I doing? I took time off around Easter but in the two weeks since April 18 I’ve cranked out five two minute monologues.

Things are looking up

Holders Technology sees the current year as “one of both significant challenge and great opportunity”, a fair assessment considering the stress on the distributor’s finances as it repositions itself in a growth market.

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Holders distributes materials used to manufacture the printed circuit boards that are ubiquitous in electronics, to wholesalers, PCB and lighting manufacturers. It diversified in 2009 when it bought JK Components, now Holders Components, a distributor of light emitting diodes. Since then its established Opteon, which markets LED lamps.

Expectations

The company faces two challenges, both with the potential to consume capital. First it must weather the vicissitudes of the PCB market as customers destock and restock according to fluctuating demand in its troubled European markets. Secondly, it’s investing in marketing its expanding range of LED products across Europe.

Bargain, recovery, cyclical, stalwart, (some potential for) growth

Holders maintains its core business is PCB materials, and since the LED opportunity is currently loss making I’m assuming the company’s earnings will remain cyclical, requiring it to maintain strong finances as a cushion during downturns.

Threats

competitive position – weak
The supply of PCB materials is a competitive market, although Holders has been in the industry since 1972 and claims long standing relationships with its suppliers. Organisations are switching to energy efficient LED lighting so it’s entered a growth market in which it already had some expertise as a distributor of materials that form the circuits that power LEDs. It’s a late entrant though, and its fledgling lamp businesses is up against successful and entrenched companies like F W Thorpe, which is also in the Thrifty 30 portfolio.

management – strong
Executive chairman Rudi Weinreich owns 45% of the company. By diversifying into a closely related business during the recession, when Holders was able to do so cheaply, Weinreich showed he’s a cautious steward who’s prepared to take calculated risks to achieve prosperity.

finances – normal
Despite the demands put on it by its two divisions, the company says it’s committed to a “conservative financial framework” and the figures bear it out. It has no long-term debt or defined benefit pension scheme and the capitalised value of its operating leases is (very approximately) 18% of tangible asset value. However, after two years of negative cash flow, Holders hasn’t got much in reserve so I don’t think its finances are especially strong.

valuation – cheap
Since Holders’ earnings from the PCB businesses are likely to remain unpredictable and earnings from the LED business are speculative, I’ve chosen to compare Holders’ market value to tangible book value. It trades at a 19% discount.

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Holders Technology is cheap but speculative. The Thrifty 30 portfolio is a happy holder, but I’ve not added more shares as a result of this review. I need profitable growth in the LED business first.

Notes

1. Holders Technology website
2. Holders Components website
3. Opteon website
4. The PCB components Holders Technology supplies
5. My Holders worksheet (two sheets)
6. More on Holders Technology and F W Thorpe
7. About the Thrifty 30.

Churchill China is a stable, profitable manufacturer of tableware with a proud heritage that has found an answer to low-cost competition. The only questionable thing about it is the price.

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Churchill China manufactures tableware in Stoke on Trent, mostly for hotels, pubs, restaurants, cruise ships and the healthcare sector. It also distributes a wider range of ceramic and glass tableware sourced abroad for independent retailers and department stores. The hospitality business is over twice the size of the retail business, which the company is shrinking. It’s emphasising quality and design, offering ‘best cost-in-use’, i.e. higher prices and fewer breakages.

Bargain/Turnaround/Cyclical/Stalwart/Growth:

Through a decade of change and investment the company has reported remarkably stable returns on capital averaging 5% without recourse to debt. It’s a modest return, but rivals went bust in the face of cheap foreign competition and recession.

Expectations:

Churchill will continue to focus on hospitality products made to a high standard in the UK. Increasing automation and innovation enable it to produce high quality attractive designs cost-effectively giving it market leadership in the UK and global ambition (37% of revenues are from abroad) . It’s committed to retrenching retail to its middle-market niche, where profit margins are higher and more reliable and Churchill’s design expertise adds value.

Threats:

competition
Churchill’s strategy is a response to low-cost competition from abroad. The company is retreating from the low-end of the retail market, where it can’t compete, and pinning its ambitions on hospitality, where superior quality and customer service matter. I think its performance shows the strategy is working.

management
Chief executive Andrew Roper has worked for Churchill China since 1973, and is one of a number of family members to have substantial shareholdings. The value of his shares is nine times his 2011 salary, which gives him an incentive to steward the company. With Roper in charge, I think Churchill China will remain a stable yet innovative business.

finances
With no debt, tiny operating leases and a modest defined benefit pension obligation the company could probably withstand a bull in its china shop.

valuation
Churchill China’s valuation is the biggest risk facing investors in a company that is otherwise almost perfect for investment. At £3.35 the company’s earnings yield is about 5%, scant return for what is admittedly little risk. Perhaps investors are paying for dependability.

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Verdict:

A 5% earnings yield is the same as a price earnings ratio of 20, which is my best estimate based on the last nine years. An investor might pay for that in a company with strong prospects for growth, and arguably, having invested so heavily, Churchill China has a more profitable future ahead of it. My perception is of a company that is holding its own against often cheaper, and often inferior, competition. It’s a company I’d like to add to the Thrifty 30, but at a lower price.

Notes:

• How I calculate the earnings yield.
• My worksheet for Churchill China.
• Best in-cost-use explained.
• Two minute monologues explained.
• More on Churchill China.