FRAN Francescas Holdings Corporation

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements concerning our business, operations and financial performance and condition as well as our plans, objectives and expectations for our business operations and financial performance and condition, which are subject to risks and uncertainties. All statements other than statements of historical fact included in this report are forward-looking statements. These statements may include words such as “aim”, “anticipate”, “assume”, “believe”, “can have”, “could”, “due”, “estimate”, “expect”, “goal”, “intend”, “likely”, “may”, “objective”, “plan”, “potential”, “positioned”, “predict”, “should”, “target”, “will”, “would” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events or trends. For example, all statements we make relating to our estimated and projected earnings, sales, costs, expenditures, cash flows, growth rates, market share and financial results, our plans and objectives for future operations, growth or initiatives, strategies or the expected outcome or impact of pending or threatened litigation are forward-looking statements.

These forward-looking statements are based on current expectations, estimates, forecasts and projections about our business and the industry in which we operate and our management’s beliefs and assumptions. These statements are not guarantees of future performance or development and involve known and unknown risks, uncertainties and other factors that are in many cases beyond our control. All of our forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from our expectations. These risks and uncertainties include, but are not limited to, the following: the risk that we cannot anticipate, identify and respond quickly to changing fashion trends and customer preferences; our ability to attract a sufficient number of customers to our boutiques or sell sufficient quantities of our merchandise through our ecommerce business; our ability to successfully open and operate new boutiques each year; and our ability to efficiently source and distribute additional merchandise quantities necessary to support our growth. For additional information regarding these and other risks and uncertainties that could cause actual results to differ materially from those contained in our forward looking statements, please refer to “Item 1A. Risk Factors,” in our Annual Report on Form 10-K for the fiscal year ended January 30, 2016 and filed with the Securities and Exchange Commission (“SEC”) on March 25, 2016, and any risk factors contained in subsequent Quarterly Reports on Form 10-Q or other filings we file with the SEC.

We derive many of our forward-looking statements from our own operating budgets and forecasts, which are based upon many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors, and it is impossible for us to anticipate all factors that could affect our actual results. All written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by the cautionary statements contained in this report as well as other cautionary statements that are made from time to time in our other SEC filings and public communications. You should evaluate all forward-looking statements made in this report in the context of these risks and uncertainties.

Potential investors and other readers are urged to consider these factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on the forward-looking statements. These forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update or revise any forward-looking statements publicly after the date of this report whether as a result of new information, future developments or otherwise.

Overview

Unless the context otherwise requires, the “Company,” “we,” “our,” “ours,” “us” and “francesca’s ^® ” refer to Francesca’s Holdings Corporation and its consolidated subsidiaries.

francesca’s ^®  is a growing specialty retailer which operates a nationwide-chain of boutiques providing customers a unique, fun and personalized shopping experience. The merchandise assortment is a diverse and balanced mix of apparel, jewelry, accessories and gifts. As of October 29, 2016, francesca’s ^® operated 669 boutiques in 48 states and the District of Columbia and also served its customers through www.francescas.com, its ecommerce website. The information contained on our website is not incorporated by reference into this Quarterly Report on Form 10-Q and you should not consider information contained on our website to be part of this Quarterly Report on Form 10-Q.

During the thirteen weeks ended October 29, 2016, our net sales increased 15% to $119.5 million from $103.7 million, income from operations increased by 42% to $15.8 million from $11.1 million and net income increased 39% to $9.7 million, or $0.26 per diluted share based on 37.7 million weighted average diluted shares outstanding, from $7.0 million, or $0.16 per diluted share based on 42.2 million weighted average diluted shares outstanding, over the comparable prior year period. During the thirty-nine weeks ended October 29, 2016, our net sales increased 12% to $340.8 million from $304.8 million, income from operations increased by 16% to $44.3 million from $38.1 million and net income increased 16% to $27.4 million, or $0.70 per diluted share based on 38.9 million weighted average diluted shares outstanding, from $23.5 million, or $0.55 per diluted share based on 42.4 million weighted average diluted shares outstanding, over the comparable prior year period.

We have increased our boutique count to 669 boutiques as of October 29, 2016 from 619 boutiques as of October 31, 2015. We plan to open five boutiques and close three boutiques during the remainder of the fiscal year.

On May 15, 2016, Michael W. Barnes resigned from his positions as Chairman, President and Chief Executive Officer (“CEO”) of the Company. As a result of such resignation, each of Mr. Barnes’ then-outstanding and unvested equity awards were forfeited. This forfeiture resulted in the reversal of $2.6 million of previously recognized stock-based compensation expense related to those unvested awards recorded during the second quarter of fiscal year 2016. Additionally, we incurred $0.6 million of professional expenses in connection with the related search process for a new CEO during the same period.

In September 2016, the Board of Directors appointed Steven P. Lawrence as the Company’s President and Chief Executive Officer effective as of October 10, 2016.

We are in the early stages of deploying a new technology suite of systems to enhance our omni-channel and customer engagement capabilities as part of our long-term strategic plan. This includes replacing our legacy point-of-sale system and introduction of a new order management system and a new customer relationship management system. The point-of-sale system is expected to be implemented during fiscal year 2017. Throughout the installation and stabilization of these new systems, we will continue to run our existing platform to ensure continuity during the conversion process. We expect that these new systems will enhance our visibility into our customers’ preferences, products and supply chain resulting in improved customer service, improved operational efficiency, enhanced management analytics and increased synergies between our ecommerce and our boutique channels.

Thirteen Weeks Ended October 29, 2016 Compared to Thirteen Weeks Ended October 31, 2015

⁽¹⁾ Percentage totals or differences in the above table may not equal the sum or difference of the components due to rounding.

Net Sales

Net sales increased 15% to $119.5 million in the thirteen weeks ended October 29, 2016 from $103.7 million in the thirteen weeks ended October 31, 2015. This increase was due to a 7% increase in comparable sales driven by the increase in the number of transactions at the boutiques and online as well as the opening of 50 net new boutiques since the comparable prior year period. Ecommerce comparable sales increased 47% to $5.7 million driven by higher website traffic and conversion rates. There were 596 comparable boutiques and 73 non-comparable boutiques open at October 29, 2016 compared to 526 and 93, respectively, at October 31, 2015.

Cost of Goods Sold and Occupancy Costs

Cost of goods sold and occupancy costs increased 12% to $61.8 million in the thirteen weeks ended October 29, 2016 from $55.4 million in the thirteen weeks ended October 31, 2015. Cost of merchandise and freight expenses increased by $5.0 million due to increased sales volume. Occupancy costs increased by $1.5 million due to the increase in the number of boutiques in operation during the thirteen weeks ended October 29, 2016 compared to the same period of the prior year.

As a percentage of net sales, cost of goods sold and occupancy costs decreased to 51.8% in the thirteen weeks ended October 29, 2016 from 53.4% in the thirteen weeks ended October 31, 2015, a favorable variance of 160 basis points. This favorable variance was due to 40 basis points improvement in merchandise margin and 120 basis points of occupancy costs leverage. The increase in merchandise margin was mostly attributable to favorable mix change and lower markdowns compared to the prior period.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 12% to $41.9 million in the thirteen weeks ended October 29, 2016 from $37.3 million in the thirteen weeks ended October 31, 2015. This increase was due to higher boutique and corporate payroll, professional fees, software costs and depreciation. The higher boutique payroll was associated with the larger boutique base while the remaining increases were due to increased strategic initiatives investments, including technology and infrastructure. As a percentage of net sales, selling, general and administrative expenses decreased to 35.0% in the thirteen weeks ended October 29, 2016 from 35.9% in the thirteen weeks ended October 31, 2016, which was driven by leveraging of expenses.

Income Tax Expense

Income tax expense increased $2.0 million in the thirteen weeks ended October 29, 2016 compared to the thirteen weeks ended October 31, 2015 due to the increase in pretax income. The effective tax rates were 38.3% and 36.7% in the thirteen weeks ended October 29, 2016 and October 31, 2015, respectively. The effective tax rate in the thirteen weeks ended October 31, 2015 was impacted by the true-up of state taxes.

⁽¹⁾  Percentage totals or differences in the above table may not equal the sum or difference of the components due to rounding.

Net Sales

Net sales increased 12% to $340.8 million in the thirty-nine weeks ended October 29, 2016 from $304.8 million in the thirty-nine weeks ended October 31, 2015. This increase is due to a 3% increase in comparable sales driven by the increase in the number of transactions at the boutiques and online as well as the opening of 50 net new boutiques since the comparable prior year period. Ecommerce comparable sales increased 41% to $15.8 million driven by higher website traffic and conversion rates. There were 596 comparable boutiques and 73 non-comparable boutiques open at October 29, 2016 compared to 526 and 93, respectively, at October 31, 2015.

Cost of Goods Sold and Occupancy Costs

Cost of goods sold and occupancy costs increased 12% to $180.1 million in the thirty-nine weeks ended October 29, 2016 from $161.2 million in the thirty-nine weeks ended October 31, 2015. Cost of merchandise and freight expenses increased by $13.1 million due to increased sales volume. Occupancy costs increased by $5.8 million due to the increase in the number of boutiques in operation during the thirty-nine weeks ended October 29, 2016 compared to the same period of the prior year. As a percentage of net sales, cost of goods sold and occupancy costs was flat compared to the same prior year period.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 10% to $116.4 million in the thirty-nine weeks ended October 29, 2016 from $105.4 million in the thirty-nine weeks ended October 31, 2015. This increase was due to higher boutique payroll to support the larger boutique base, as well as an increase in corporate payroll, marketing, professional fees, software costs and depreciation. The increase in marketing expense was due to the implementation of new marketing initiatives while the higher corporate payroll, professional fees, software costs and depreciation was due to increased strategic initiatives investments, including technology and infrastructure. These increases were partially offset by a $2.0 million net benefit associated with the resignation of our previous CEO and the related search process. As a percentage of net sales, selling, general and administrative expense decreased to 34.1% in the thirty-nine weeks ended October 30, 2016 compared to 34.6% in the thirty-nine weeks ended October 1, 2015 primarily due to the net benefit associated with the resignation of our CEO.

Income Tax Expense

Income tax expense increased $2.5 million in the thirty-nine weeks ended October 29, 2016 compared to the thirty-nine weeks ended October 31, 2015 due to the increase in pretax income. The effective tax rates were 38.0% and 37.7% in the thirty-nine weeks ended October 29, 2016 and October 31, 2015, respectively.

(1) Excludes gift card breakage income, shipping and change in return reserve.

Liquidity and Capital Resources

Our primary sources of liquidity are cash flows from operations and borrowings under our revolving credit facility. Our primary cash needs are for capital expenditures in connection with opening new boutiques and remodeling existing boutiques, investing in improved technology and distribution facility enhancements, funding normal working capital requirements and payments of interest and principal, if any, under our revolving credit facility. We may use cash or our revolving credit facility to issue letters of credit to support merchandise imports or for other corporate purposes. The most significant components of our working capital are cash and cash equivalents, merchandise inventories, accounts payable and other current liabilities. Our working capital position benefits from the fact that we generally collect cash from sales to customers the day of or, in the case of credit or debit card transactions, within several days of the related sales and we typically have up to 30 days to pay our vendors.

We were in compliance with all covenants under our revolving credit facility as of October 29, 2016. At October 29, 2016, we had $24.7 million of cash and cash equivalents and approximately $75.0 million in borrowing availability as no borrowings were outstanding under our revolving credit facility.

We expect that our cash flow from operations along with borrowings under our revolving credit facility and tenant allowances for new boutiques will be sufficient to fund capital expenditures and our working capital requirements for at least the next twelve months.

Operating Activities

Operating activities consist of net income adjusted for non-cash items, including depreciation and amortization, deferred taxes, the effect of working capital changes and tenant allowances received from landlords. Net cash provided by operating activities was $35.5 million and $30.4 million in the thirty-nine weeks ended October 29, 2016 and October 31, 2015, respectively. The increase in cash provided by operating activities was primarily due to the increase in net income, as adjusted for non-cash items, as well as timing of payments for inventory purchases and income taxes, partially offset by changes in landlord incentives and deferred rent in connection with new boutiques.

Investing Activities

Investing activities consist primarily of capital expenditures for new boutiques, improvements to existing boutiques, as well as investment in information technology and our distribution facility.

Our total capital expenditures for the thirty-nine weeks ended October 29, 2016 and October 31, 2015 were $18.7 million and $19.9 million, respectively, with new boutiques accounting for most of our spending at $11.5 million and $12.6 million, respectively. Spending for new boutiques included amounts associated with boutiques that will open subsequent to the end of each fiscal quarter. We opened 59 boutiques in the thirty-nine weeks ended October 29, 2016 compared to 80 boutiques in the thirty-nine weeks ended October 31, 2015. The average cost of the leasehold improvements, equipment, furniture and fixtures, excluding tenant allowances which are reflected in operating cash flows, for new boutiques opened in the thirty-nine weeks ended October 29, 2016 and October 31, 2015 was $234,000 and $220,000, respectively. The average tenant allowance per new boutique in the thirty-nine weeks ended October 29, 2016 and October 31, 2015 was $77,000 and $78,000, respectively. Tenant allowances are amortized as a reduction in rent expense over the term of the lease. The average collection period for these allowances is approximately six months after boutique opening. As a result, we fund the cost of new boutiques with cash flow from operations, tenant allowances from our landlords, or borrowings under our revolving credit facility. Our spending for existing boutiques totaled $3.3 million and $5.2 million during the thirty-nine weeks ended October 29, 2016 and October 31, 2015, respectively. The majority of the current year expenditure was spent on remodeling 31 boutiques while the prior year amount was for updating display fixtures and equipment and remodeling 25 boutiques.

Management anticipates that capital expenditures for the remainder of fiscal year 2016 will be approximately $6.4 million to $9.4 million. The majority of this amount will be spent on new and existing boutiques as well as investments in our information technology systems.

Financing Activities

Financing activities consist of borrowings and payments under our revolving credit facility, repurchases of our common stock, and proceeds from the exercise of stock options and the related tax consequence.

Net cash used in financing activities was $48.3 million during the thirty-nine weeks ended October 29, 2016 which consists of $48.7 million in repurchases of our common stock and $0.4 million in proceeds from the exercise of stock options and the related tax consequence. Net cash used in financing activities totaled $7.6 million during the thirty-nine weeks ended October 31, 2015, which consists of $7.9 million in repurchases of common stock and $0.3 million in proceeds from the exercise of stock options and the related tax consequence.

Revolving Credit Facility

On August 30, 2013, Francesca’s Collections, Inc. (or the “Borrower”), as borrower, and its parent company, Francesca's LLC, a wholly owned subsidiary of the Company, entered into a Second Amended and Restated Credit Agreement with Royal Bank of Canada, as Administrative Agent and Collateral Agent, and the lenders party thereto. The credit facility provides capacity of $75.0 million (including up to $10.0 million for letters of credit) and matures on August 30, 2018. The facility also contains an option permitting the Borrower, subject to certain requirements and conditions, to arrange with the lenders for additional incremental commitments up to an aggregate of $25.0 million, subject to reductions in the event the Borrower has certain indebtedness outstanding. At October 29, 2016, there were no borrowings outstanding under the credit facility.

The credit facility contains customary events of default and requires the Borrower to comply with certain financial covenants. As of October 29, 2016, the Borrower was in compliance with all covenants under the credit facility. The credit facility restricts the amount of dividends the Borrower can pay; provided that the Borrower is permitted to pay dividends to the extent it has available capacity in its available investment basket (as defined in the Second Amended and Restated Credit Agreement), no default or event of default is continuing, certain procedural requirements have been satisfied and the Borrower is in pro forma compliance with a maximum secured leverage ratio. At October 29, 2016, the Borrower would have met the conditions for paying dividends out of the available investment basket. All obligations under the credit facility are secured by substantially all the assets of the Borrower and any subsidiary guarantor, if any. All obligations under the facility are unconditionally guaranteed by, subject to certain exceptions, Francesca’s LLC and each of the Borrower’s existing and future direct and indirect wholly-owned domestic subsidiaries.  

Share Repurchase Program

For information regarding our share repurchase program, please refer to Note 7 to our unaudited consolidated financial statements included in Part I of this report, which is incorporated herein by reference.

Critical Accounting Policies

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, as well as the related disclosures of contingent assets and liabilities at the date of the financial statements. A summary of the Company’s significant accounting policies is included in Note 1 to the Company’s annual consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 30, 2016.

Certain of the Company’s accounting policies and estimates are considered critical, as these policies and estimates are the most important to the depiction of the Company’s consolidated financial statements and require significant, difficult, or complex judgments, often about the effect of matters that are inherently uncertain. Such policies are summarized in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of our Annual Report on Form 10-K for the fiscal year ended January 30, 2016. As of October 29, 2016, there were no significant changes to any of our critical accounting policies and estimates as disclosed in our Annual Report on Form 10-K for the fiscal year ended January 30, 2016.

Recent Accounting Pronouncements

For information regarding recent accounting pronouncements, please refer to Note 1 to our unaudited consolidated financial statements included in Part I of this Report, which is incorporated herein by reference.

Contractual Obligations

There were no significant changes to our contractual obligations and commercial commitments as disclosed in our Annual Report on Form 10-K for the fiscal year ended January 30, 2016, other than those which occur in the normal course of business.

Off Balance Sheet Arrangements

We are not party to any off balance sheet arrangements.