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FRAN: SSSG Trends Since 2010 |
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Unfortunately for Francesca’s Holdings Corp (NASDAQ:FRAN), the deteriorating operating performance has translated directly to a declining stock price and valuation. Since its IPO, after accounting for the customary pop that occurred on the day of the IPO, FRAN’s stock price has since declined by 47%. Also, FRAN’s EV/Revenue and EV/EBITDA multiples have tumbled to 1.8x and 7.5x, respectively, a far cry from the 8x EV / revenue and 31x EV / EBITDA valuation the day after its IPO.
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FRAN: Valuation Decline Since IPO |
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On its latest earnings call, Francesca’s Holdings Corp (NASDAQ:FRAN)’s management described the difficult retail environment as well as the challenges related to keeping ahead of trends for its targeted customer demographic.
Overall, the retail environment has been challenging since the beginning of the calendar year, withsoft traffic trends and competitively aggressive promotions. The cumulative effect of these trends has limited the effectiveness of our merchandise clearance strategies, and has created bottlenecks in inventory flow for newness.
Our customer demographic trends respond best to well-edited assortments, newness, and lower price point items with a higher perceived value. Although motivated, she is not heavily interested in clearance. Even with our short lead times, we struggled to effectively clear during extended periods of slow traffic, and have limited space to maneuver from an inventory perspective. – Neill Davis, Francesca’s Holdings Corp (NASDAQ:FRAN) President and CEO on Q1’14 Earnings Call
This commentary highlights the difficulty of managing merchandise for a fickle demographic. While Five Below Inc (NASDAQ:FIVE) has been fairly successful with its concept thus far, the company is still in the early innings of a long and difficult road to national expansion. We believe that Five Below is prone to missing a merchandising trend periodically and that a severe miss has the potential to trigger a significant valuation correction, particularly if Five Below mismanages a holiday quarter.
Overall, we feel that Francesca’s Holdings Corp (NASDAQ:FRAN)’s trends and history offer investors valuable lessons in what could go wrong with a fast-growing retailer. Like Five Below Inc (NASDAQ:FIVE), FRAN also benefited from high SSSG, high revenue growth and sell-side analyst optimism during its early part of the growth phase. As FRAN is now in the intermediate stage of its expansion plan, it is having a challenging time managing a significantly larger store base. New competition, the challenge of managing exponential growth, combined with being forced to enter 2nd and 3rd tier markets, has led to the declining revenue and SSSG growth trend that have severely impacted FRAN’s valuation. Interestingly, FRAN continues to rapidly expand store count (25% increase in FY 2013), but that has not masked other fundamental issues that we’ve outlined. We believe that Five Below’s recent trends imply a similar trajectory and that it’s only a matter of time before investors are less optimistic about Five Below’s overhyped potential.
Case Study: Denninghouse
Next, we’ll examine Denninghouse, a concept that operated in the same segment as Five Below Inc (NASDAQ:FIVE): discount retail. Just like Five Below is now a darling among sellside analysts who cover dollar stores, Denninghouse was once Canada’s hottest discount retail growth brand. Despite growing its store count and revenue nearly 1,000% over a 10-year period and achieving record financial results nearly every year, Denninghouse’s competitive position was quickly ravaged by competition, resulting in the company’s bankruptcy in 2004, only 2 years after it achieved its most profitable year in existence. The Denninghouse story offers instructive lessons for investors in easy-to-copy specialty retail formats.
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Denninghouse: Stock Price Performance from 2001 – 2005 |
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(Source: Denninghouse annual report)
Denninghouse was a Canadian discount specialty retailer that operated the “Buck or Two” stores – a line of small-format retail stores, averaging ~3,000 square feet, that sold a variety of seasonal and everyday items below a C$2.00 price point. Denninghouse started with a single store in 1987, and grew modestly until its management decided to pursue an aggressive franchising strategy in 1992.
(Source: Denninghouse public filings)
Over the next decade, Denninghouse’s growth exploded. Within only six years, Denninghouse become the largest discount retailer in Canada, with over 200 stores across Canada and system-wide sales of nearly C$130 million. As Denninghouse grew, shareholders benefited from its attractive unit-level economics. Denninghouse operated with a very small store format – approximately 3,000 square feet – and thus it posted strong sales per square foot of ~C$240.00. Given the minimal costs to open a store, Denninghouse was able to attract hundreds of franchisees, more than doubling its unit count again between 1998 and 2002, peaking at 328 stores in 2002.
During its growth years, Denninghouse had many stark similarities with Five Below Inc (NASDAQ:FIVE) today:
- Denninghouse was a Canadian discount retailer that went through a rapid growth phase, going from only a handful of stores in 1987 to 328 stores by 2003 (given the Canadian market is approximately 1/10th the US market, that is equivalent to a penetration of about 3,200 stores in the US. To further put that in context, FDO, DG and DLTR currently have approximately 8,000, 11,000 and 5,000 stores in the United States, respectively)
- Denninghouse also focused largely on selling seasonal items and close-out merchandise, rather than consumables and household items which correspond to a more recurring revenue stream.
- Denninghouse also sold its products at a relatively higher gross margin than its competitors (Denninghouse gross margins were in the high-30%’s, versus low-20%’s for Wal-Mart).
- Denninghouse also had attractive unit-level economics, with a small-format store (~3,000 square feet) and sales per square foot in line with industry levels at the time (C$240/foot).
Despite putting up incredible growth and record profits year-after-year, Denninghouse blindsided investors with an incredibly rapid deterioration in profits. Denninghouse went from hitting record profits in calendar 2002 to being bankrupt by 2004! So how did Canada’s leading national discount retailer go from setting record profits, to going bankrupt, in only 2 years?
Seasoned investors could see troubling signs that the company’s strategic position was under attack from competition many years before its eventual bankruptcy in 2004.
As Denninghouse grew its store base, it faced the same challenge every high-growth specialty retailer faces: finding attractive locations. Initially, Denninghouse capitalized on its most attractive markets with the best customer demographics and the least competition. However, as the company was faced with the challenge of maintaining its compounding growth, Denninghouse was forced to enter 2nd and 3rd tier markets. These markets were not as attractive as its initial stores, and thus did not have the same store-efficiency. As these stores matured, Denninghouse’s growth in same store sales began to show a troubling and precipitous decline several years before its bankruptcy in 2004.
(Source: Denninghouse public filings)
Second, Denninghouse faced the inevitable risk that investors consistently ignore: new competition. Though Denninghouse had a unique specialty retail concept, the company had no sustainable competitive advantages. Its cost basis was not lower than that of its competitors’ (including the rapidly growing Dollarama, which was later acquired by KKR). It sold products at a higher margin than did competitors like Wal-Mart and Costco, which left Denninghouse vulnerable to price undercutting by rivals. Its merchandising concept could be easily replicated and the company did not have a brand name or other type of loyalty that could retain foot traffic.
Like Five Below Inc (NASDAQ:FIVE), Denninghouse merely provided a niche merchandise offering which was successful while it was a small, nimble retailer. But once Denninghouse became large enough and competitors took notice, Denninghouse’s strategy was quickly copied and the company’s sales and profits were decimated. When explaining how Denninghouse went from achieving its peak profitability in fiscal year 2003 to a record reversal only a year later, the MD&A explained:
The Company attributes these declines to increased competition as the number of stores operating within this retail sector continues to increase and other retail formats including supermarkets are testing or adding “dollar sections” within some of their stores. – Denninghouse MD&A, FY2004
Five Below will Not Go Bankrupt, but the Denninghouse Example Demonstrates Why It Shouldn’t Be Trading at 50x P/E
Over the coming years, Five Below Inc (NASDAQ:FIVE) will face all of the challenges that Denninghouse faced during its torrid expansion, and eventual implosion, several years ago. However, given Five Below’s current valuation at 50x PE, investors have given themselves little margin of safety for any operational missteps or competitive pressures.
Perhaps most significantly, Five Below is set to face a torrent of new competition from copy-cats. Like Five Below Inc (NASDAQ:FIVE), Denninghouse was a leading discount retailer with phenomenal growth, great unit economics and a niche strategy. However, Denninghouse, like Five Below, had minimal sustainable competitive advantages. Once it became large enough that competitors took notice, Denninghouse and its shareholders were caught blindsided by the competitive attacks from copy-cat retailers and established incumbents. Denninghouse went from its most profitable year to bankruptcy in only 2 years! Investors could have seen troubling signs in Denninghouse’s same-store-sales years before its eventual bankruptcy.
As we referenced extensively in our prior article, Five Below Inc (NASDAQ:FIVE) shareholders should be particularly concerned given that Wal-Mart’s small-format stores, which are arguably the biggest competitive threat for the retailer, are expected to make significant inroads into the discount retailing market next year. Dollar General has already indicated a plan to attack Five Below’s market aggressively. Despite these incredibly hostile competitive threats, investors appear to be valuing FIVE as if its growth was almost certain – we think this is a terrible risk/reward.
Second, Five Below must continue to call the trends amongst its fickle teenage clients correctly. Given that Five Below Inc (NASDAQ:FIVE) is a heavily seasonal retailer and generates almost all of its operating profit during the holiday (Q4) quarter, competitors like Dollar General and Wal-Mart can make very targeted attacks on the company through national, regional and online
